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A financial audit model for entrepreneurial governments

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A financial audit model for entrepreneurial governments

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A FINANCIAL AUDIT MODEL
FOR ENTREPRENEURIAL GOVERNMENTS
by
Kenneth Abel Macias
A Dissertation Presented to the
FACULTY OF THE SCHOOL OF POLICY, PLANNING,
AND DEVELOPMENT
UNIVERSITY OF SOUTHERN CALIFORNIA
In Partial Fulfillment of the
Requirements for the Degree
DOCTOR OF PUBLIC ADMINISTRATION
August 2000
Copyright 2000 Kenneth Abel Macias
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UMI Number: 3018104
Copyright 2000 by
Macias, Kenneth Abel
All rights reserved.
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UNIVERSITY OF SOUTHERN CALIFORNIA
SCHOOL OF POLICY, PLANNING, AND DEVELOPMENT
UNIVERSITY PARK
LOS ANGELES, CALIFORNIA 90089
This dissertation, written by
Kenneth _ A . _ M acias............................................
under the direction o f hSs.... Dissertation
Committee, and approved by all its
members, has been presented to and
accepted by the Faculty o f the School o f
Policy, Planning, and Development, in
partial fulfillment o f requirements fo r the
degree of
DOCTOR OF PUBLIC ADMINISTRATION
D IS S E R TA TIO N CO
'Chairperson
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Kenneth Abel Macias
(Student)
Ross Clayton
(Committee Chair)
DISSERTATION ABSTRACT
A FINANCIAL AUDIT MODEL
FOR ENTREPRENEURIAL GOVERNMENTS
This study was conducted to develop a theoretical government audit
model that incorporates entrepreneurial risks. Entrepreneurial activities are
increasing in today’s operational environments. The existing financial
government audit model, the American Institute of Certified Public
Accountants’ (AICPA) Audits of State and Local Governmental Units, does not
specifically address this area. This study defined public entrepreneurship as,
“the risky use of public resources in the creation of value to the people.”
Exploratory research was performed for determining internal forces that
affect governmental audits and for developing a theoretical model. A review of
existing models identified accounting policies, internal control environment,
and government mechanisms as significant internal forces. Meta analysis
supported the inclusion of entrepreneurial activities as another significant
internal force. A literature review was performed on various administrative
theories and frameworks; a theoretical government audit model was
developed from this analysis. Survey responses from prominent experienced
auditors and users of government financial audits confirmed the model and the
concepts embodied in it.
The model framework was based on Kolb’s (1976) Learning Style
Profile. This framework uses opposing concepts to highlight measurable
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responses. Participant(s) responses show observable patterns. The
framework was redesigned to show opposing significant internal forces -
accounting policies vs. entrepreneurial activities and internal control
environment vs. government mechanisms. The theoretical network included
agency, risk, institutional, and entrepreneurship theories. A descriptive
analysis connected forces with the theoretical network. Pragmatic applications
related observable audit patterns for different government audit scenarios to
auditors’ degrees of risk and audit procedures.
This preliminary research supported the following seven propositions:
Proposition 1 — The AICPA Audits of State and Local Governmental Units is
the most important audit model. Propositions 2 to 5 - Accounting policies,
internal control environment, government mechanisms, and entrepreneurial
activities are significant internal forces affecting government financial audits.
Proposition 6 — The existing model does not effectively address how to audit
entrepreneurial activities. Proposition 7 — Users of governmental audits
expect complex, risky entrepreneurial transactions are being audited.
This research concludes with implications for future research and audit
practice. One project could be to apply the proposed audit model to GASB
Statement No. 34’s new reporting model.
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ACKNOWLEDGEMENTS
My experience with earning the Doctor of Public Administration degree
has been enriching and somewhat liberating. The coursework was rigorous,
relevant, and insightful, especially classical works from scholars such as
Weber, Marx, Madison, Wilson, Mead, Deming, Eisenhardt, Schon, Osborne,
and Gaebler. As a narrowly trained professional accountant, this tremendous
body of work was sometimes difficult to grasp. This enormous task was made
significantly easier by the senior level professors who taught for USC. I am
deeply indebted to professors John Kirlin, Chester Newland, Jeff Chapman,
and Ross Clayton for broadening and enriching my conceptual and pragmatic
thinking. Their collective guidance and consistent encouragement navigated
me through the program's body of knowledge.
The doctoral program was liberating because it taught me how to
effectively draw from my experiences, relationships, and passions. My
experience auditing governments was particularly helpful in developing a
theoretical framework for this dissertation. Therefore, I must acknowledge my
professional auditing mentors and teachers - Mark Rodebaugh, Phillip Calder,
Tom Allen, Ernie Gini, and Caroline Walsh.
My extended family and friends have been an integral part in
developing my values and shaping my personality, particularly my father,
Albert Macias and mother, Rita Macias. I also would like to thank all my
talented classmates for consistently enriching the program for me, particularly
Helen Lake, Connie Fajardo, Donna Stahl, and Yvonne Kochanowski.
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One of my many passions is skiing. I will always cherish the memory of
being challenged by Dr. Kirlin to relate my daydreaming of ski turns to his
lecture on theory development. Much to the awakened amazement of my
fellow doctoral classmates, I coherently managed to pull it off!
My partners and staff deserve a lot of credit for my professional and
academic success. All of them made it possible for me to pursue the
doctorate degree. I particularly want to thank my partners Ernest J. Gini,
Kevin J. O'Connell, and Richard A. Green in seeing the value for our firm in
pursuing this degree.
I want to also thank the members of my dissertation committee - Ross
Clayton (Chair), Chester Newland, and Keith Comrie - for helping me through
this fulfilling and arduous assignment. I am particularly grateful for Dr.
Clayton's scholarship, patience, and guidance.
My secretary, Linda Martin, has been a wonderful resource and friend.
She has been retyping and editing my work for approximately eleven years. I
simply could not have completed this dissertation without her assistance. We
often joke about how I am such a "high maintenance" person.
I want to thank my family for inspiring me to be a better person. My
son, Daniel and daughter, Laura Lou allowed me to study along side them and
remarkably understood why Dad could not always be there for them. Finally, I
want to acknowledge my Mrs. Everything, Joyce. She is my friend, partner,
and wife who has unconditionally encouraged me to achieve every important
goal through our life journey together.
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TABLE OF CONTENTS
ACKNOWLEDGEMENTS.......................................................................................... ii
LIST OF TABLES..................................................................................................... viii
LIST OF FIGURES......................................................................................................x
CHAPTER 1: A NEED TO IMPROVE THE FINANCIAL AUDIT MODEL FOR
GOVERNMENT ORGANIZATIONS..................................................1
1.1 Introduction...................................................................................1
1.2 List of Abbreviations....................................................................2
1.3 Statement of the Problem...........................................................3
1.4 Definition of Entrepreneurial Activity and Risks...................... 3
1.5 Background..................................................................................6
1.6 Questions Answered By This Study.........................................8
1.7 Why Research is Important..................................................... 10
1.8 How the Dissertation Unfolds..................................................20
1.9 Conclusion and Transition to Chapter 2 ................................ 21
CHAPTER 2: META ANALYSIS OF ENTREPRENEURIAL ACTIVITY............. 23
2.1 Introduction............................................................................... 23
2.2 Orange County’s Bankruptcy..................................................25
2.3 Special Financing Districts...................................................... 40
2.4 Performance Measurement System.......................................44
2.4.1 Government Financial Environment............................44
2.4.2 Background on Performance Measures.....................45
2.4.3 Background on Performance Budgeting.....................49
2.4.4 Preliminary Conclusions............................................... 54
2.5 Conclusion and Transition to Chapter 3 ................................57
CHAPTER 3: CURRENT STATE AND LOCAL GOVERNMENT AUDIT
STANDARDS AND REPORTING MODELS.................................. 58
3.1 Introduction................................................................................58
3.2 General Accounting Office Auditing Standards....................58
3.2.1 Applicability................................................................. 59
3.2.2 Accountability..............................................................59
3.3 AICPA Auditing Guide..............................................................65
3.3.1 The Development of the Audit G uide......................69
3.3.2 1998 ASLGU...............................................................73
3.3.3 Internal Control Environment.................................... 79
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TABLE OF CONTENTS
(continued)
3.4 Single Audit Act and OMB Circular A-133.......................... 82
3.4.1 Background................................................................. 82
3.4.2 New Single Audit Act and OMB Circular A-133
Requirements.............................................................. 86
3.5 GASB Reporting Model..........................................................93
3.5.1 Entity-wide Perspective (EW P)................................95
3.5.2 Fund Perspective....................................................... 96
3.5.3 Management Discussion and Analysis................... 98
3.6 Conclusion and Transition to Chapter 4 ...............................99
CHAPTER 4: THEORETICAL MODELS AND LITERATURE REVIEW..........101
4.1 Introduction.............................................................................101
4.1.1 Theory Construction for Public Administration .... 102
4.1.2 Program Evaluation Theory.....................................106
4.1.3 Recent Public Administration Fad..........................109
4.2 Public Entrepreneurship........................................................113
4.3 Risk Theory.............................................................................119
4.4 Institutional Theory.................................................................123
4.4.1 Background.................................................................124
4.4.2 Institutional Theory.................................................... 127
4.5 Agency Theory....................................................................... 134
4.6 Conclusion and Transition to Chapter 5 ..............................142
CHAPTER 5: DEVELOPMENT OF AN IMPROVED FINANCIAL AUDIT
MODEL FOR GOVERNMENT ORGANIZATIONS................... 145
5.1 Introduction............................................................................ 145
5.2 Accounting Policies............................................................... 147
5.2.1. Background............................................................... 147
5.2.2. Theoretical Framework............................................ 151
5.2.3. Conclusion................................................................ 153
5.3 Internal Control Environment................................................ 154
5.4 Government Mechanisms....................................................157
5.4.1. Background............................................................... 157
5.4.2. Theoretical Framework............................................ 159
5.4.3. Conclusion................................................................ 160
5.5 Entrepreneurial Activity........................................................ 161
5.6 Assessed Levels of R isk......................................................163
5.7 Proposed Audit Model...........................................................165
5.8 Conclusion and Transition to Chapter 6 ..............................169
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TABLE OF CONTENTS
(continued)
CHAPTER 6: RESEARCH PROBLEM, EXPECTATIONS, DESIGN,
AND METHODOLOGY................................................................175
6.1 Introduction............................................................................. 175
6.2 Research Problem and Expectations.................................. 175
6.3 Research Design and Methodology.....................................178
6.3.1. Design....................................................................178
6.3.2. Methodology..........................................................180
6.3.3. The Study’s Propositions.....................................183
6.4 Importance of Study.............................................................186
6.5 Limitations of Study..............................................................187
6.6 Conclusion and Transition to Chapter 7 ........................... 188
6.6.1. Summary............................................................... 188
CHAPTER 7: ANALYSIS OF RESPONSES TO SURVEY FROM AUDITORS
OF GOVERNMENT FINANCIAL STATEMENTS...................... 190
7.1 Introduction..............................................................................190
7.2 Response Rates.....................................................................190
7.3 Survey Questionnaire............................................................191
7.4 Application of Proposed Audit Model.................................. 203
7.5 Conclusion and Transition to Chapter 8..............................208
CHAPTER 8: ANALYSIS OF RESPONSES TO SURVEY FROM USERS OF
GOVERNMENT FINANCIAL STATEMENTS............................ 212
8.1 Introduction............................................................................. 212
8.2 Response Rates.....................................................................212
8.3 Survey Questionnaire............................................................213
8.4 Application of Proposed Audit Model.................................. 219
8.5 Conclusion and Transition to Chapter 9..............................225
CHAPTER 9: CONCLUSIONS, IMPLICATIONS AND SUGGESTIONS
FOR FUTURE STUDIES............................................................ 228
9.1 Study’s Objectives and Conclusions...................................228
9.1.1 Background...............................................................228
9.2 Statement of the Research Question..................................229
9.2.1 Theory Development............................................... 230
9.2.2 Propositions............................................................. 230
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TABLE OF CONTENTS
(continued)
CHAPTER 9: CONCLUSIONS, IMPLICATIONS AND SUGGESTIONS
FOR FUTURE STUDIES (CONTINUED)
9.3 Implications of Study............................................................234
9.3.1 Theoretical Framework........................................... 234
9.3.2 Audit Procedures for Entrepreneurial R isks 235
9.3.3 Application of Proposed Model.............................. 236
9.3.4 Applying the Proposed Model to GASB Statement
No. 34........................................................................242
9.4 Suggestions for Future Studies.......................................... 245
REFERENCES.......................................................................................................247
APPENDIXES........................................................................................................255
A Auditors Survey Questionnaire State and Local
Government Audit Model...............................................................255
B Users of Government Audits Survey Questionnaire
State and Local Government Audit Model..................................260
C Audit Procedures for Common Entrepreneurial Activities...........265
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LIST OF TABLES
Chapter 1
1 -1 List of Abbreviations........................................................................................ 2
1 -2 Questions Answered By This Study............................................................ 10
1 -3 Importance of Research................................................................................20
Chapter 2
2-1 California Government Code Sections........................................................38
2-2 State and Local Financial Auditors’ Concerns Over a Performance
Measurement System .................................................................................. 56
Chapter 3
3-1 Government Auditing Standards Financial A udits.....................................61
3-2 Generally Accepted Government Auditing Standards
Standards of Fieldwork................................................................................. 62
3-3 Aspects of Internal Control........................................................................... 63
3-4 Editions of ASLGU.........................................................................................72
3-5 The Earliest and Most Recent ASLGUs......................................................76
3-6 Risk Factors for Government Financial A udits...........................................83
3-7 Compliance T esting....................................................................................... 88
3-8 Internal Control Responsibilities...................................................................90
3-9 Reporting for Single Audits............................................................................92
Chapter 4
4-1 Broad Theoretical Categories For Governmental Financial Auditing... 105
4-2 Broad and Detailed Theoretical Categories For Governmental Financial
Auditing.........................................................................................................109
4-3 Entrepreneur vs. Democratic Values......................................................... 117
4-4 Financial Statement Risk Areas.................................................................121
4-5 Consideration of Fraud in Financial Statement Audits............................ 123
Chapter 5
5-1 Aspects of Internal Control......................................................................... 155
Chapter 7
7-1 Improving Government Audit Model Survey Results...............................191
7-2 Improving Government Audit Model Respondents’ (Auditors’)
Background Information............................................................................. 193
7-3 Chi Square Analysis of Important Forces Affecting Government
. Financial Audits............................................................................................ 195
7-4 Chi Square Analysis of Entrepreneurial Activity Expectation
Gap Government Financial Audits.............................................................196
7-5 Improving Government Audit Model Respondents’ (Auditors’)
Audit Effort in Other Major Areas...............................................................199
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LIST OF TABLES
(continued)
Chapter 7 (continued)
7-6 Improving Government Audit Model Respondents’ (Auditors’)
Auditing Procedures for Entrepreneurial Transactions...........................201
7-7 Improving Government Audit Model Respondents’ (Auditors’)
Survey Results............................................................................................ 202
Chapter 8
8-1 Improving Government Audit Model Respondents’ (Users’)
Background Information............................................................................. 216
8-2 Improving Government Audit Model Respondents’ (Users’)
Experiences and Observations With Government
Financial Auditors........................................................................................217
8-3 Improving Government Audit Model Respondents’ (Users’)
Government Organization’s Entrepreneurial Activities...........................218
8-4 Improving Government Audit Model Respondents’ (Users’)
Survey Results............................................................................................ 220
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LIST OF FIGURES
Chapter 2
2-1 Interest Rate Changes.................................................................................. 29
2-2 Orange County Leveraging Method............................................................ 30
Chapter 3
3-1 Levels of Auditing Standards........................................................................ 66
3-2 Illustration of the Minimum Requirements for General Purpose
External Financial Reporting.......................................................................97
Chapter 4
4-1 Theories and Methodologies Audit Model Proposed in Chapter 5.........144
Chapter 5
5-1 Forces Affecting the Audit Approach Theoretical Categories and
Methodologies.............................................................................................147
5-2 Proposed Government Audit M odel.......................................................... 167
5-3 Proposed Government Audit Model Big County or City...........................171
5-4 Proposed Government Audit Model Grant Specific
Organization/Program................................................................................172
5-5 Proposed Government Audit Model Entrepreneurial Government........ 173
Chapter 6
6-1 Proposed Government Audit M odel.......................................................... 181
Chapter 7
7-1 Proposed Government Audit Model Big County or City...........................205
7-2 Proposed Government Audit Model Grant Specific
Organization/Program............................................................................... 207
7-3 Proposed Government Audit Model Entrepreneurial Government........210
Chapter 8
8-1 Proposed Government Audit Model Big County or City...........................222
8-2 Proposed Government Audit Model Grant Specific
Organization/Program............................................................................... 224
8-3 Proposed Government Audit Model Entrepreneurial Government........226
Chapter 9
9-1 Proposed Government Audit Model Big County or City.......................... 238
9-2 Proposed Government Audit Model Grant Specific
Organization/Program............................................................................... 241
9-3 Proposed Government Audit Model Entrepreneurial Government........244
X
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CHAPTER 1
A NEED TO IMPROVE THE FINANCIAL AUDIT MODEL
FOR GOVERNMENT ORGANIZATIONS
1.1 INTRODUCTION
This dissertation research is completed in partial fulfillment for the
Doctor of Public Administration degree requirements of the University of
Southern California. Entrepreneurial activity in government organizations is
increasing, and there are concerns about the risks associated with this kind of
activity. Users of government financial audits expect auditors to perform work
in this area. The current financial audit model for government organizations
provides little guidance on entrepreneurial activity. Auditing activity in
government organizations has been studied, but this study provides significant
insight into user expectations, as well as suggestions on auditing
entrepreneurial risks in government organizations. This study also establishes
a theoretical framework for a financial audit model for government
organizations.
1.2 LIST OF ABBREVIATIONS
The use of abbreviations is prevalent in the government financial
auditing field. Hence, a list of abbreviations used in this study is presented in
table 1 -1 for those readers who may be unfamiliar with their meanings.
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Table 1-1
List of Abbreviations
AGA Association of Government Accountants
AICPA American Institute of Certified Public Accountants
ASLGU Audits of State and Local Governmental Units
BA Bachelor of Arts
BBA Bachelor of Business Administration
BS Bachelor of Science
CAFR Comprehensive Annual Financial Report
CDBG Community Development Block Grant
CGFM Certified Government Financial Manager
COD Codification of Governmental Accounting and Financial
Reporting Standards
COPS Certificate of Participations
CPA Certified Public Accountant
DCA Department of Consumer Affairs
DOR Degrees of Risk
ED Exposure Draft
EDP Electronic Data Processing
EDU Equivalent Dwelling Unit
EWP Entity-wide Perspective
FOR Forensic Auditor
FP Fund Perspective
GAAP Generally Accepted Accounting Principles
GAAS Generally Accepted Auditing Standards
GAGAS Generally Accepted Government Auditing Standards
GAO General Accounting Office
GASB Governmental Accounting Standards Board
GFOA Government Finance Officers Association
JPA Joint Powers Agreement
JTPA Job Training Partnership Act
LSI Learning Style Inventory
MD&A Management’s Discussion and Analysis
MID Modesto Irrigation District
NPR National Performance Review
OMB Office of Management and Budget
SAS Statement on Auditing Standards
SDA Service Delivery Area
SEA Service Efforts and Accomplishments
SOP Statement of Position
TQM Total Quality Management
USDA United States Department of Agriculture
(Original table)
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1.3 STATEMENT OF THE PROBLEM
Dissertation Problem Statement: How can independent financial
auditors incorporate entrepreneurial risk into the state and local
government financial audit model?
1.4 DEFINITION OF ENTREPRENEURIAL ACTIVITY AND RISKS
A recurrent movement is to have government organizations operate more
like businesses. Osborne and Gaebler’s (1993) book, Reinventing
Government, was about making government organizations more
entrepreneurial. Apparently, the public’s perception is that businesses use
their resources more efficiently than governments do. This study is about how
to effectively audit “entrepreneurial” activity. An obvious starting point for the
study is to establish a working description of entrepreneurial activity in public
organizations. The following three researchers have provided descriptions in
their work.
Fisher (1981) emphasized that the term, “entrepreneur,” comes from the
private business world. The term is largely reserved for those rugged
individuals who have invested their time, talent, and resources in a risky
venture and, incidentally, have been successful. J. B. Say, a French
economist and disciple of Adam Smith, coined the expression back in the early
1800s to identify the person who directs resources from less productive into
more productive investments, thus creating wealth. The entrepreneur must be
prepared to risk his/her reputation and to invest time and energy into the
realization of ideas that are only defendable on the basis of future outcomes,
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not current gains. Fisher also believes entrepreneurship is antithetical to
bureaucracy and largely alien to public governance. The entrepreneur must
constantly scan the boundaries of the system and find ways to poke holes in it.
Chapman’s (1996) definition for public entrepreneur might well be
adjusted to a modified version -- the risks that an entrepreneur may take can
only lead to smaller gains in the worst case, and never to losses. Chapman
analyzed entrepreneurial activity in Orange County’s risky investment
practices that led to the County’s bankruptcy. He believes that three
conclusions can be drawn from that situation. The first is that an uncertain
price must be paid for being an entrepreneur. A second conclusion is that
entrepreneurship in the public sector is different than in the private sector.
The third lesson is that entrepreneurial uncertainty in the public sector
generates additional constraints (government codes, laws, and regulations) on
entrepreneurial activity in order to protect the public from poor decision
making.
Kirlin (1995) believes that contemporary public administration, writings,
and reform efforts often undervalue the large roles that governments must
successfully perform in providing institutional frameworks for human activity.
He uses “Public Entrepreneurship"as a term to describe value creation. His
definition for entrepreneurship is a commitment to change, wealth creation,
and value-adding processes. When one adds the modifier, “public,” this
means to create value without which “private” entrepreneurship would be rare
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and very difficult. Kirlin also believes that increasing the value of places (the
locations where people live) is the primary function of governments.
Osborne and Gaebler believe entrepreneurial government searches for
more efficient and effective ways of managing (Osborne and Gaebler, 1992, p.
18):
It is willing to abandon old programs and methods. It
is innovative and imaginative and creative. It takes
risks. It turns city functions into money-makers rather
than budget-busters. It eschews traditional
alternatives that offer only life-support systems. It
works with the private sector. It employs solid
business sense. It privatizes. It creates enterprises
and revenue generating operations. It is market
oriented. It focuses on performance measurement. It
rewards merit. It says, “Let’s make this work,” and it is
unafraid to dream the great dream.
These researchers’ views can be used to establish a working definition
and description for this study. An interesting observation is that all three of the
researchers first described the “process” of being an entrepreneur or
entrepreneurship. Fisher describes creating wealth; Chapman, Osborne, and
Gaebler describe taking risks; and Kirlin describes value-adding processes.
Chapman and Kirlin’s descriptions are somewhat opposites of each other,
which reflect the studies they performed. Fisher’s description is similar to
Kirlin’s description; however, later in his study, he describes the risks
entrepreneurs must take to achieve their visions.
An auditor must understand the processes of creating wealth and
adding value that entrepreneurs envision. These processes are labeled as
entrepreneurship in this study. Since this study is about government
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organizations, a further label of public entrepreneurship is used. Financial
auditors are more concerned about the organization’s risks. Degrees or levels
of risk in financial audits are discussed in Chapter 5. Chapman and Fisher
emphasized that risks are associated with entrepreneurship.
A study on improving the financial audit model for government
organizations should include the term “risk” in its working definition. This
study’s definition for public entrepreneurship is the risky use of public
resources in the creation of value for the people. Entrepreneurial activity is
more of a descriptive phrase in this study. Chapman used Orange County’s
risky investment practices as an example of entrepreneurial activity in
government organizations. The next chapter further analyzes Orange
County’s investment practices and other examples of entrepreneurial
activities.
It is also important to describe a public entrepreneur. A public
entrepreneur is an individual who takes risks with public resources in creating
value for the people. As Osborne and Gaebler noted, these enterprising
individuals are needed to create imaginative and effective ways to deliver
efficient public services. However, it is the financial auditor’s role to properly
monitor and report entrepreneurial activity in government organizations.
1.5 BACKGROUND
Osborne and Gaebler (1993) in Reinventing Government wrote about
dealing with the crisis of government today. The purpose of their book was to
help map a direction for government. They suggested that government
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organizations should be more entrepreneurial. Many government
organizations are getting involved in risky transactions to help balance their
budgets and to provide services. Audit procedures need to be developed by
auditors to keep pace with this emerging entrepreneurial, governance
paradigm.
The main objective of the government audit model is to verify account
balances at year-end. This approach does not always emphasize the
understanding and testing of the internal control environment. In addition, the
model does not emphasize that auditors should also understand and test
governance mechanisms that guide and regulate transactions. The prevailing
approach also does not emphasize identifying and determining risks
associated with entrepreneurial activity.
The American Institute of Certified Public Accountants (AICPA) has
developed the existing government audit model (AICPA, 1998). The model is
a consensus of 15 members of the AlCPA’s Government Accounting and
Auditing Committee. The Committee’s generally accepted practice
procedures are not grounded in a theoretical framework. The development of
auditing procedures to audit public entrepreneurial risk should be grounded in
a theoretical framework uniquely designed for government organizations.
This dissertation is anchored in agency, risk, institutional, and
entrepreneurship theories. These theories provide the background and insight
necessary to design an improved audit model that can be used to effectively
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audit accounting systems and governance mechanisms while considering
entrepreneurial activity.
1.6 QUESTIONS ANSWERED BY THIS STUDY
The last major revisions of the government auditing standards
(GAGAS) issued by the Comptroller General of the United States (1994) and
the AICPA Audits of State and Local Governmental Units (ASLGU) (1998)
were in 1994. Neither of these government auditing models emphasize risky
types of transactions generally associated with entrepreneurial activities. In
addition, these models are not grounded in a theoretical framework.
This study answers several questions in regards to state and local
government financial audits. An important question is simply what is the
working definition of entrepreneurial activities? Also, the study provides
examples of activities. Another question is why entrepreneurial transactions
are considered more risky than other government transactions? How should
an auditor go about auditing these types of transactions?
This study identifies and defines risks associated with government
financial audits. In the GAGAS and ASLGU models, risks associated with
government financial audits are discussed; however, auditors’ approaches in
addressing risk are often inconsistent. These models do not include risks
associated with entrepreneurial activity or market risks. This study suggests
that governments are becoming more creative in using their resources to
provide services to constituents. This study answers the question, how should
auditors adjust their approach for each audit?
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The study also surveys users and auditors of state and local
government financial audits. The survey instruments are designed to answer
the question of whether there are any expectation gaps between these two
groups. It has long been suspected that users of government financial audits
believe that audits include entrepreneurial activity. The survey instruments
should also answer questions on what users want from local and state
government financial audits. The auditors’ survey clarifies what procedures
actually are performed. The survey instruments also seek input on the
auditing of entrepreneurial activities.
The study also suggests changes to the auditor’s risks associated with
financial statement audits. According to Generally Accepted Auditing
Standards (GAAS) issued by the AICPA (1998), risks associated with financial
audits normally include inherit, control, and detection risks. This study
answers the questions on whether these risk areas are the only ones in
government financial audits. The study fully identifies and defines major risk
areas. The study also connects these risk areas along with other important
risk areas to applicable theoretical administrative frameworks. The study then
answers the question, how might a theoretical government financial audit
model be created? How can the model be illustrated, including all its
dimensions? Finally, how can the model be practically applied?
Table 1-2 summarizes questions answered by this study.
This study is more descriptive in its approach because it must first
describe how audit practice is conducted today, particularly in identifying audit
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risk areas and the use of current government audit models. Afterwards, the
study links practice to theoretical administrative frameworks that both describe
and prescribe audit approaches to cover risk areas. The study ends with the
creation of a theoretical state and local government financial audit model. The
model provides practical audit procedures for certain entrepreneurial activities.
In addition, it also prescribes ways to emphasize different risk areas for each
audit.
Table 1-2
Questions Answered By This Study
1. What is the working definition of entrepreneurial activities?
2. Why are entrepreneurial activities more risky than other
transactions?
3. What should be an auditor’s approach to entrepreneurial
activities?
4. How do auditors adjust their approach for each audit?
5. Are there expectation gaps between users and auditors of state
and local financial audits?
6. What do users want from these audits?
7. What audit procedures are actually performed?
8. How are risk areas for state and local financial audits identified?
9. How might a theoretical government financial audit model be
created?
10. How can the model be practically applied?
(Original table)
1.7 WHY RESEARCH IS IMPORTANT
America is competing more than ever in the global economy. To
successfully compete in that economy, businesses are streamlining their
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operations and reducing overhead. Many of the country’s businesses would
like to reduce government overhead. One way to reduce overhead is simply
to have more income remain in the nation’s businesses rather than having
them pay taxes. Another way to reduce governments’ overhead is by having
them be more efficient and productive with their resources. Governmental
efficiencies can be achieved by being creative with the services they offer to
businesses. An example of being creative is privatizing certain services.
Another example is establishing performance measures to develop and
achieve systems that can help improve performance. These kinds of changes
may require structural changes to the organization. Structural changes, such
as decentralizing authority, can increase risk. As a result, there is a need to
challenge the current government financial audit model to properly evaluate
structural changes within state and local governments.
Osborne and Gaebler (1993) wrote about dealing with the crisis of
government today. These authors pointed out that most government is not in
Washington D.C., but in the many cities, counties, and districts throughout the
country. Osborne and Gaebler suggested government organizations should be
more entrepreneurial and provided examples throughout the book of how
other government organizations have been successful using entrepreneurial
methods and principles. Entrepreneurial governments typically have moved
from centralization to decentralization, from a monopoly to competition, from
bureaucratic mechanisms to market mechanisms, from politically-driven
citizens to customer-driven systems, from rule-driven organizations to mission-
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driven organizations. These authors provide ten principles of entrepreneurial
governments.
1. Act as catalysts
2. Competitive
3. Mission driven
4. Shift accountability to outcomes, producing results-oriented
government
5. Customer driven
6. Anticipatory
7. Community owned an idea of earning money
8. Decentralized to foster flexibility
9. Market-oriented
10. Enterprising: Earning rather than spending
The current state and local government financial audit model does not
emphasize auditing of an entrepreneurial approach to providing services.
There is a perception in today's society that government should operate
more like business. Aspiring politicians have grasped this perception and
used it to get elected. Once in office, they have followed through with their
platforms to change government operations. Many of the proposed changes
make governments more risky. Fine (1998) recently wrote about the changes
Mayor Riordan has made since becoming Mayor of the City of Los Angeles.
The author said that the Mayor has had several chiefs of staff, and he has
often changed his approach in dealing with the operations of the City. Fine
believes the reason for this is his managerial style. Riordan’s style is much
more entrepreneurial and less reflective of how a bureaucrat typically
operates. The Mayor is quick to advance a prospect he likes and trusts, like
his last Chief of Staff, but is just as quick to drop that “investment” if his
expectations are not met. What matters to him most are results. With a
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hostile City Council and a huge bureaucracy that is slow to change, his
premium on results is summed up by this mantra: Better to ask forgiveness
than to seek permission. The key to success in this kind of environment is
being able to make things happen according to William Ouchi, the UCLA
Anderson School of Management Dean, who served as Riordan’s Chief of
Staff from 1994 to 1995.
A powerful elected official or appointed administrator is nothing new to
the government industry. Caro (1975) wrote a book called The Power Broker.
The book was about Robert Moses, New York City’s Parks Commissioner
from approximately the1920s to the 1940s. Mr. Moses was a powerful
government administrator who often usurped authority and used power to
achieve his policies and goals for the City. Caro showed how someone like
Moses could gain power and maintain it for a long time in a democratic
society. The book is a good example of how one individual, using the power
derived from several self-interested individuals, can control administrative
policies.
Caro showed how a powerful official’s administrative policies have a
profound impact on the general public. The entrepreneurial paradigm being
adopted by many government organizations today is creating positions of
power. These positions may be beneficial in conducting operations, but they
could put government organizations at additional risk. It is important for the
audit model to cover increased risk associated with the broadening of authority
of administrators and elected officials.
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In California, local government organizations do not have total control
over their operations. Walters (1998) observed that the 1978 property tax
reduction measure, Proposition 13, had many financial and political impacts.
The most enduring, which was not envisioned, was the massive shift of
political authority from locally-elected city councils, county boards of
supervisors, and school board members to the state Capitol. The education
establishment partially insulated itself in 1988 by gaining voter approval of
another initiative, Proposition 98, which guaranteed schools a major portion of
the state’s revenues. Cities have developed a modicum of independence by
developing new revenue sources that are fairly safe from state depredation.
Counties, however, remain largely dependent on the whims of the governor
and the Legislature.
The voters who passed Proposition 13 over 20 years ago were intent
on curbing runaway property taxes; they did not suspect that they also were
weakening their own ability to understand and control government. The
control of property taxes was obtained at a big price. Citizens lost control of
tax fairness, experienced less services and declining schools, and noticed
distortions in land use. A system that loads a higher tax burden on young
households and new businesses while ignoring real economic development is
neither fair nor good for economic growth. The most important enduring
legacy and irony of Proposition 13 is how it moved power away from local
communities to the state Capitol.
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As a result, it has become more difficult for citizens to know who is in
charge of, and accountable for, the services provided to them. If there are not
enough police, does one complain to City Hall or to state government?
According to a 1998 Sacramento Bee opinion piece, the state filched $3.6
billion of local property tax revenues in the early 1990’s to close a state budget
deficit. In a world where success goes to the agile and flexible, where
decentralized decision-making and accountability are favored, Proposition 13
and its offspring have created a system of California governance where power
has moved to the top and policy is, increasingly, written in stone.
Complicated inter-governmental budgeting decreases the control that
lower governments have over their operations. In California, local
municipalities are developing innovative ways of providing services with less
control and resources. These new methodologies for providing services
increase risk areas for public resources. It is important for this study to
research additional risk areas that may be caused by inter-government
budgeting. It is also important for this study to prescribe a theoretically based
methodology that can cover these risks.
The Governmental Accounting Standards Board (GASB) has revised
the financial reporting model for state and local governments (GASB, 1999).
GASB is changing its reporting model because the current model has been
used for several decades. GASB’s (1997) objective with the new model is to
establish a basic financial reporting model that will result in greater
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accountability by state and local governments by providing more useful
information to a wider range of users than the existing model.
GASB’s Concept Statement 1, paragraph 30 (GASB, COD, 1999)
identifies three groups of primary users of a government’s external general-
purpose financial report, “(a) Those to whom government is primarily
accountable (the citizenry), (b) those who directly represent the citizens
(legislative and oversight bodies), and (c) those who lend or who participate in
the lending process (investors and creditors).” Accountability is the paramount
objective of government financial reports—the objective from which all other
financial reporting objectives flow (GASB, COD, 1999). Government’s duty to
be accountable includes providing financial information that is useful for
economic, social, and political decisions. Financial reports that contribute to
these decisions include information useful for (a) comparing actual financial
results with the legally adopted budget, (b) assessing the financial condition
and results of operations, (c) assisting in determining compliance with finance-
related laws, rules, and regulations, and (d) assisting in evaluating efficiency
and effectiveness. Information needs have developed as the activities of
governments have become more complex and as transactions that do not
require the use of current financial resources have become more common.
User needs require a longer-term perspective of governmental activities and a
more comprehensive view of all activities.
GASB's Preliminary Views document (1992) explains the evolution of
financial reporting and seeks interested parties' views on establishing
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reporting standards for Service Efforts and Accomplishments (SEA) data. The
GASB feels that in addition to standard financial information, SEA measures
are very helpful to policy makers, management, and constituents. GASB
explains different types of SEA measures and how an organization might
record, maintain, and report the information. The major reason for measuring
SEA is increased accountability. SEA measures provide information that is
useful in assessing whether an entity's agencies, departments, programs, or
services are achieving their goals and objectives economically, efficiently, and
effectively.
Significant change in the financial reporting model requires revising the
existing state and local government financial audit model. The need for SEA
data to be included in the Comprehensive Annual Financial Report (CAFR) will
also require a change in the auditor’s approach. It is important to the field of
local government financial auditing that a framework be established to address
these changes in financial reporting. This study proposes an audit framework
that will address these new reporting changes.
Local government entities in California are becoming more involved in
complex transactions. Closing budget gaps to provide services is one reason
given for being involved in complex transactions. Many of these transactions
can be labeled entrepreneurial activities. The Orange County bankruptcy is a
good example of entrepreneurial transactions. Chapman (1996) labeled the
Orange County Treasurer as a public entrepreneur. He believes there are two
types of entrepreneurs. The first is the true entrepreneur who takes
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unconstrained risks in the hope of making larger gains. This is the definition of
a private sector entrepreneur. In the public sector, the definition might well be
adjusted to the modified version -- the risks that an entrepreneur may take can
lead only to smaller gains in the worst case, never to losses. In Orange
County, the Treasurer modeled himself after the first type of entrepreneur. His
investment strategies lost nearly $2.0 billion.
Sjoberg (1995), California’s State Auditor, reported that the Orange
County Treasurer violated the basic principles of prudent investing. He made
investments that were unsafe, highly risky, and extremely volatile. He
leveraged the portfolio more than 2.7 times and invested more than 40 percent
in inverse floaters and other structured securities. He also violated his trust
responsibilities by altering accounting records and misallocating earnings and
losses.
Government financial auditors should have an audit model that
addresses complex, entrepreneurial transactions. The existing model does
address how an auditor should audit cash and investments, but it does not
provide guidance on complex, entrepreneurial activities. The importance of
this study is to determine if users of government financial audits expect
auditors to audit these kinds of transactions. This study also suggests a
methodology for how to audit these kinds of transactions and other types of
risk areas.
The state and local government audit model does cover most significant
areas and transactions. However, as previously discussed, numerous
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changes are occurring in California’s local governments. Through local
businesses, local governments are indirectly competing in the global economy.
Local governments must continue to try to reinvent themselves, perhaps,
using many entrepreneurial methods and activities. Strong politicians and
administrators must be catalysts and leaders to steer governments to change
their operational methodologies. In California, there continues to be more
movement towards centralizing budgetary and operational control in the state
government. This centralized structural approach began developing as a
result of Proposition 13. All of these developments have increased the use of
complex, entrepreneurial transactions. These kinds of transactions increase
risk because most of them reduce accountability to the citizenry.
Table 1-3 summarizes why research is important.
The audit model needs to keep pace with the ever-changing
developments in the California local government industry. The audit model
needs to focus on significant areas. Perhaps, one way of determining areas of
significance is identifying, understanding, and challenging risk areas. The
existing model does discuss accounting control, fraud, and legal risk areas.
However, this study documents that an additional significant area is
entrepreneurial risk. The objective of this study is to improve the existing
model so that it has the flexibility to deal with the unique changes facing
California’s local government agencies.
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Table 1-3
Importance of Research
1. To determine methodologies in properly evaluating changes
caused by global competition.
2. To provide suggestions on improving the existing state and local
audit model to incorporate entrepreneurial activities.
3. To determine the effects of officials’ broadening authority.
4. To determine the effects of California’s centralization of budget
control.
5. To develop audit methodologies that incorporate GASB’s
planned financial reporting model and SEA measures.
6. To develop an audit model that can be adjusted to cover risk
involving complex transactions.
7. To identify expectation gaps between auditors and users of
government audits.
8. To provide a working definition of entrepreneurial activities.
9. To develop audit procedures for entrepreneurial activities.
10. To identify areas for future research.
(Original table)
1.8 HOW THE DISSERTATION UNFOLDS
At first, this study is descriptive, and then it becomes more prescriptive.
The next chapter provides examples of entrepreneurial transactions and
activities that have recently occurred in several California local government
agencies. These examples identify the risks in each of the entrepreneurial
activities. It is important to this study to describe, understand, and analyze
these transactions and activities. Chapter 3 describes the existing state and
local government financial audit model. In addition, GASB’s new reporting
model is described and analyzed. Chapter 4 is the last of the descriptive
chapters; it provides background necessary to prescribing changes. This
chapter uses four theoretical approaches to anchor the suggested new audit
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model. The four theoretical areas are agency, risk, institutional, and
entrepreneurship.
Chapter 5 is a more prescriptive chapter. This chapter prescribes an
improved financial audit model for government organizations. The chapter
also illustrates a flexible framework to assess risk areas and how they should
be audited. Chapter 6 provides the study’s methodological approach, gives
details on survey instruments, and lists seven propositions that are later
assessed. Chapters 7 and 8 analyze responses to the two survey instruments
used in this study. The survey instruments were sent to both users and
auditors of government financial audits. The main reason these instruments
were developed and used was to provide insight into the expectations of
government financial audits. Chapter 9 of this dissertation provides
conclusions and a summary of the dissertation’s implications, and it offers
suggestions for future research.
1.9 CONCLUSION AND TRANSITION TO CHAPTER 2
It is important to improve the local government financial audit model for
California. Society still highly values the concept of accountability for public
resources. Government organizations are involved with innovative and risky
transactions when providing services to their people. These transactions have
been defined in this study as entrepreneurial activities. This study’s definition
for public entrepreneurship is the risky use of public resources in the creation
of value for the people.
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The next chapter provides three examples of entrepreneurial activities.
The chapter describes, explains, and analyzes risks associated with these
activities. The background from this chapter is used later in the study to
analyze the suggested new government financial audit model.
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CHAPTER 2
META ANALYSIS OF ENTREPRENEURIAL ACTIVITY
2.1 INTRODUCTION
The Sacramento Bee reported in 1999 that the County of Sacramento
was considering financing a baseball stadium (Martineau, 1999). The County
Board of Supervisors unanimously approved a proposal that could bring
professional baseball to the area by Spring 2000. A Joint Powers Agreement
(JPA) between three government agencies would provide the financing to
build the 10,000-seat Triple A baseball stadium. The City of West Sacramento
guaranteed one-third of $40 million in bonds for construction of the baseball
stadium, while the County of Sacramento guaranteed two-thirds or roughly
$26.6 million. The County of Yolo is to return to the JPA any sales tax
revenue generated by the stadium, which opened for play in May 2000.
Critics of the stadium proposal are concerned about risks the County of
Sacramento is taking with public funds. The County believes that there will be
sufficient additional sales tax revenues, owner reserves, and other revenues to
pay the bonds. The objective of the three government agencies is to create a
public good -- a community sports facility, which houses a team. Chapter 1 of
this study defined public entrepreneurship, as the risky use of public resources
in the creation of value for the people. The Sacramento Bee article described
an example where government agencies were getting involved in a risky,
complex entrepreneurial activity.
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The City of Fort Bragg learned in 1999 that governmental funds were
being subsidized by enterprise funds. According to a local article (Boyle,
1999), an independent financial audit performed by Macias, Gini & Company
llp showed the City of Fort Bragg was “in the hole” for just over $1 million.
The auditor cited a pattern of deficit spending over several years that put the
City in this position. The City's annual operations were balanced by massive
borrowing from rate paying funds meant to maintain and improve the water
and sewer utilities complex. The auditors were concerned about when the
borrowing would stop and the repaying would begin. In California, under
Proposition 218, this type of borrowing could be illegal. The transfer of funds
in this fashion could be thought of as an additional tax on local citizens. A
local tax requires a two-thirds vote.
Transfers of enterprise funds to subsidize the operations of
governmental funds within a local government are complex, entrepreneurial
transactions. Such transfers are complex because the government is
increasing its legal risk by challenging the boundaries of designated funds. It
is entrepreneurial because administrators are betting (market risk) on how well
the local economy will perform to generate government revenues to pay the
debt.
According to the 1999 article on Fort Bragg, Councilman Gjerde asked
the auditor what role his firm played in informing the Council about the deficits
(Boyle, 1999). O’Connell, a partner in the firm of Macias, Gini & Company,
replied that, unless specifically requested, his firm does not make a public
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presentation on their yearly audit findings. The question by the councilman is
interesting because it implies that expectations are that auditors should be
evaluating and reporting on these kinds of transactions. Chapter 3 of this
study shows that it is not clear whether auditors are responsible for reporting
on complex, entrepreneurial transactions and activities.
The remaining sections of this chapter provide three more examples of
entrepreneurial activities. The three examples are Orange County’s
Bankruptcy, special financing districts that have been created in California,
and performance measurement systems. The separate sections for each of
these examples provide background and analyses on risk areas associated
with these entrepreneurial activities. The examples from this chapter are used
later in the study to aid in the analysis of the suggested new government
financial audit model.
2.2 ORANGE COUNTY’S BANKRUPTCY
Osborne and Gaebler (1992) identified the 1978 passage of Proposition
13 as one of the important reasons for the emergence of entrepreneurial
government in California. Another reason was President Reagan’s substantial
reduction of federal revenues to state and local governments nationwide.
Osborne and Gaebler posit that California’s government officials had no
choice but to embrace “public-private partnerships” and develop “alternative”
ways to deliver services. State and local governments are providing the same
services with fewer revenues, and they need alternatives to balance their
budgets. A method used by the County of Orange (Orange County) was
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earning higher rates of return on riskier investments. Their investment
practices ultimately led to the County going bankrupt as a result of losing
approximately $1.69 billion, approximately $600 million of which was allocable
(on a pro rata basis) to the County’s accounts (Sjoberg, 1995). All of the
remainder was allocable to accounts of non-County pool participants, such as
cities, school districts and special districts (County of Orange, 1998).
Although the Orange County Bankruptcy was a community tragedy,
there is a lot we can learn from it. The Orange County Treasurer is
responsible for receiving and keeping safe all funds belonging to the County
and other investors in its investment pools. The California State Auditor found
that the former Treasurer pursued an investment strategy that violated the
basic principles of prudent investing, which are safety, liquidity, and yield, in
that order. In fact, the Treasurer’s investment strategies were opposite to
these principles. The former Treasurer’s investments were unsafe, highly
risky, and extremely volatile; and they lacked the liquidity needed to meet the
portfolio’s objectives. His strategy failed when he sacrificed safety and
liquidity to capture higher yields. The former Treasurer did this by leveraging
the portfolio more than 2.7 times and purchasing highly volatile inverse floaters
and other structured securities that comprised more than 40 percent of the
investments (Sjoberg, 1995).
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Furthermore, the California State Auditor found the following:
• The former treasurer violated his trust responsibilities to
participants in the investment pool. When the county and
other public entities deposit their funds into the county
treasury, a trust relationship is established between the
treasurer and these entities;
• The treasurer’s office altered county accounting records for
investment pool interest earnings. As a result, the county’s
general fund received approximately $93 million more interest
earnings than it was entitled to receive from the investment
portfolio;
• The treasurer’s office inappropriately transferred securities
from the county’s specific investment account. At the time of
the transfers, the county’s securities had accumulated a $271
million loss that was shared by all pool participants;
• Eight of the 14-brokeraae firms that we surveyed reported
that they had revenues of at least $21.3 million in 1994 and
$46.3 million in 1993 from financial transactions with the
county. The remaining 6 did not provide compensation
information. Further, the State Auditor believed that most of
the firms did not disclose all their compensation earned on
investment transactions with the county; and
• The county estimated that approximately $23.7 million would
be spent for bankruptcy-related costs through June 30, 1995.
The county retained ten firms to provide various services,
including legal services for the bankruptcy, litigation services,
and advisory services. (Sjoberg, pp. S-1 - S-2, 1995)
The Orange County Treasurer’s investment practices were highly risky,
extremely volatile, and lacked liquidity. This strategy involved leveraging or
borrowing billions of dollars against the portfolio to obtain cash for
investments. The borrowed funds were then used to purchase securities
known as derivatives that were highly sensitive to changes in interest rates.
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Figure 2-2 illustrates Orange County’s leveraging method. This strategy
earned above-average returns during a several-year period from 1991 to
1993. In fact, several governments outside the County eagerly invested in the
county investment pools. The County’s strategy was very sensitive to
changes in interest rates. The County’s investments were more valuable and
able to support a highly leveraged position as long as interest rates continued
to stay even or go down. Unfortunately, during 1994, interest rates went up
several times. Figure 2-1 shows the interest rate changes from January 1991
through November 1994 when the County filed for protection under Chapter 9
of the United States Bankruptcy Code (County of Orange, 1998).
Orange County’s investment strategies were complex entrepreneurial
transactions. The County was involved in risky investment practices in an
attempt to enhance their portfolio’s value. Chapman (1996) also felt that the
investment strategies of the County’s Treasurer were entrepreneurial
transactions. Chapman believes there are two types of entrepreneurs. The
first is the true entrepreneur who takes unconstrained risks in the hope of
making larger gains. This is the definition of a private sector entrepreneur.
But in the public sector, the definition might well be adjusted to the modified
version — the risks that an entrepreneur takes lead only to smaller gains in the
worst case, and never to losses. In Orange County, the Treasurer modeled
himself after the first type of entrepreneur.
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Figure 2-1
Interest Rate Changes
January 1991 through November 1994
Average of Bid/Offer Rate
8.0
7.0
6.0
5.0
4.0
3,0 * 1 * - ‘ * 1 ‘ 1 * * -* 1 • 1 - ■ «-■»-« i » » -« ■ » ■ ■ ■ « ■ i « « ■ ■ « » ■ «
3 N 3 s 3 V 3 s 3 n 3 n S ' S ' S ' S ' S ' S S ’ J P ^ v 1 * J * J * *
6-M onth LIBOR —• — 3-Y ear Treasury ♦ - - 5-Y ear T reasury
Note: LIBOR: London Interbank Offer Rate
Source: Interactive Data Corporation
(Sjoberg, p. 4, 1995)
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Figure 2-2
Orange County Leveraging Method
ORANGE COUNTY BROKERAGE FIRM
COLLATERAL (102%)
©
$1 million
Treasury Bill
2 1/2 years at
$980,000
REVERSE
REPO AGREEMENT
r
I $1 million
\ Treasury Bill
1 2 1/2 years at 6!
I * -
$980,000 LOAN
AT REPO RATE (5%)
180 days
I
ORANGE CO UNTY PURCHASES
©
t
j $980,000
\ Corporate Bond
) 4 years at 7%
$960,000
%
*
J
©
ORANGE COUNTY
PURCHASES,
t
$960,000
FNMA
5 years at 7.5%
$940,000
REVERSE
REPO AGREEMENT
COLLATERAL (102%)
r
$980,000
Corporate Bond
► i ------- r - — --------------
I 4 years at 7%
$960,000 LOAN
AT REPO RATE (5%)
180 days
COLLATERAL (102%)
REVERSE
REPO AGREEMENT
r
I $960,000
^ \ FNMA
J 5 years at 7.
$940,000 LOAN
AT REPO RATE (5%)
180 days
(Sjoberg, p. 12, 1995)
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Chapman also emphasized that entrepreneurs do not exist in a
vacuum. They need an organizational culture that either supports them or
ignores their activities and methods because it is pleased with the results of
the entrepreneur’s efforts. If the culture is supportive, the entrepreneur is
encouraged to let others know of the activities that are being undertaken. If
the entrepreneur is ignored, there is likely to be much less knowledge of the
methods and activities. In this case, if there are initially small problems, they
may become large because of this deliberate ignorance.
The Orange County Treasurer was ignored and, as a result, became
more aggressive and bold with his investment strategies, which became riskier
over time. In fact, he was encouraged by the community because he was
reelected a couple of years before the crisis. His opponent, who became the
Treasurer after the crisis, ran on a conservative investment strategy platform.
An element of the Treasurer’s investment strategy was borrowing short to buy
long (Figure 2-2); he exposed the portfolio to significant risk by buying long
term securities with short-term borrowing. The incentive for using this
approach is to obtain the higher rate of return available on longer term
investments, and to profit from the spread between the investment’s earnings
and the costs of borrowing. According to the GFOA’s committee on Cash
Management (AICPA, 1998), the conservative and prudent approach to
borrowing with reverse repurchase agreements (a vehicle for borrowing) is to
match the maturity date of the asset purchased with the due date of the
reverse repurchase agreement. At one time, it was documented that the
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Treasurer followed this conservative approach. However, the former
Treasurer apparently changed his approach. In 1994, the average maturity of
the reverse repurchase agreements, which comprised more than 60 percent of
the portfolio, was considerably less than half a year. In contrast, the average
years to maturity of the total portfolio was nearly four years (Sjoberg, 1995).
On December 6, 1994, the County of Orange filed for protection under
Chapter 9 of the United States Bankruptcy Code (County of Orange, 1998). In
response to the bankruptcy, the County prepared a comprehensive recovery
plan that also addressed the County’s budget deficit that resulted from its
investment losses. The plan incorporated budget cuts, administrative
reorganization, a settlement agreement with pool participants, and various
methods to raise funds. The primary methods for raising funds included
issuing bonds and prosecuting and collecting upon all pool-related claims.
It has been more than four years since the bankruptcy. Harrell (1998)
reported in an article about the “Orange County Bankruptcy Update” that the
County filed several lawsuits that sought more than $5 billion in damages from
brokerage firms, lawyers, accountants, and Standard & Poor’s. This included
$3 billion from KPMG Peat Marwick, and another $2 billion from Merrill Lynch.
Merrill Lynch agreed to pay $400 million to resolve all claims against it,
including claims from other local governments. Merrill Lynch also agreed to
return $20 million in collateral to Orange County, which was not part of the
overall recovery since the Orange County Investment Pool owned the
collateral. Other key settlements also occurred. KPMG Peat Marwick settled
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its lawsuit for $75 million. KPMG was accused of failing to detect
approximately $150 million that was illegally shifted from the investment
portfolio to other county accounts. Orange County officials “concealed their
illegal activities during our audit,” said a KPMG spokesman. The County also
said KPMG failed to warn it about risky derivative investments. Orange
County also settled with Credit Suisse First Boston Corporation for $52.5
million. Credit Suisse sold only 4% of the securities that led to the County’s
losses. The New York law firm of LeBoeuf, Lamb, Greene & MacRae agreed
to pay more than $55 million to settle civil claims stemming from its work as
bond counsel for the County in the mid-1900s. Morgan Stanley/Dean Witter &
Company and Nomura Securities together agreed to pay the County a total of
nearly $117.5 million for allegedly failing to properly disclose risks. The total
recoveries from lawsuits thus far have been more than $739 million. The
County’s school districts have already recovered 98% of their losses, said the
City Manager of Irvine and Chairman of the Orange County Investment Pool
Committee. Other agencies will be able to recover more than 90% of their
losses after they receive the proceeds from the settlement with Merrill Lynch.
The County itself, however, is only now starting to share in the recovery.
Using Osborne and Gaebler’s (1992) descriptions of entrepreneurial
activities, the Orange County investment strategies can be described as a
catalytic approach to government. Their chapter on catalytic government
provided several examples of public organizations increasing resources
through innovative methods. One method was simply using community
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development to generate tax revenues. These authors emphasized the need
to redefine the role of government and to separate “steering” from “rowing.”
The policymakers that provide direction to the organization (steering) should
be separate from service delivery (rowing). This allows them to be flexible
with whom they use to deliver services. This approach allows policymakers to
use competition between government employees and private contractors. The
authors believe accountability for quality performance can be improved
because contractors know they can be replaced if their quality sags; civil
servants know they cannot.
Unfortunately, the Orange County catalytic approach to government
failed because the Treasurer lost the ability to achieve entrepreneurial tenets
like flexibility, competition, and accountability. His investment strategy was no
longer flexible and competitive after borrowing short to buy long. After having
earlier successes with his investment strategy, he was not being held
accountable. In fact, the state and local financial audit model for the cash and
investments area was not designed effectively enough to deal with this kind of
entrepreneurial activity.
The audit model gave guidance on how to audit and report, but it was not
enough. Even today’s audit model falls short of providing a framework to deal
with entrepreneurial transactions. In the cash and investment area, the audit
mode! only refers the auditor to reporting requirements written by the
Governmental Accounting Standards Board (GASB) and discusses how an
auditor should obtain an understanding of internal controls over cash and
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investments. Since 1994, the reporting of investment transactions has
improved with the issuance of GASB Statement No. 31, “Accounting and
Financial Reporting for Certain Investments and for External Investment
Pools” (1997). The statement now requires most investments to be reported
at fair value rather than amortized costs. Thus, at least annually, governments
need to adjust their financial statements to reflect the fair value of their
investments.
The audit model still falls short in understanding entrepreneurial activity
in public organizations. The audit model says auditors should also consider
the various types of risks involved, including business risk, market risk, credit
risk, and risk of collateral loss, as well as the steps taken by the governmental
unit to control those risks (AICPA, 1998). The audit model still does not go far
enough with a framework. It also falls short in describing how an auditor
should obtain evidence and information when auditing complex,
entrepreneurial activity. This framework should help the auditor understand
how to adjust his or her approach for each type of entrepreneurial activity.
Chapter 5 proposes an audit model that may be adjusted for several types of
entrepreneurial activities, such as risky investment strategies.
Another thing that can be learned from the Orange County Bankruptcy
is understanding how governments deal with crises. Johnston (1996)
observes that local governments in the United States have faced significant
fiscal challenges since the 1970s. He points out several reasons for these
challenges and notes that a great deal of criticism has also been leveled at
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antiquated government management practices. He further observes that
municipal governments have been criticized for being ineffective, inefficient,
and incapable of responding to the changing social, technological, and fiscal
environment. It has frequently been suggested that government’s traditional
aversion to risk, and the procedural and cultural environment created by this
institutional risk aversion, inhibit the ability of government bureaucracies to
respond to change generally and to crisis situations in particular.
Participants in the County’s investment pool had little or no warning of
the impending crisis, little time to react, and no bankruptcy court protections.
Most of these agencies were placed into an immediate fiscal crisis status.
Johnston studied how two of the public agencies dealt with the fiscal crisis.
He studied the City of Montebello (City) and the Orange County Transportation
Authority (Authority). He observed that the City’s bureaucratic structure made
it less effective in dealing with the crisis. The City was reacting to pressures it
was under from the community and its creditors. In contrast, the Authority was
taking more of a proactive approach to the crisis. The Authority’s early public
statements did not convey a sense of crisis because they quickly grasped the
severity of the situation and moved aggressively to head off the potentially
disastrous consequences. The Orange County Bankruptcy reminds us of the
possible crises governments are now facing. In order to audit and properly
report the variety of possible crises and normal operating scenarios, an
adjustable audit approach needs to be developed. This approach should
address the new government paradigm of being less bureaucratic and more
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flexible and responsive. The audit model suggested in Chapter 5 can be
tailored to deal with public agency crises.
Chapman (1996) identified at least three basic conclusions that can be
drawn from the events that transpired in Orange County. The first is that there
is a price to be paid for being an entrepreneur. That price is increased
uncertainty concerning the outcome of any activity. These costs are
measured by losses in opportunities to obtain the highest return on activity. In
effect, return is traded for security. A second conclusion is that
entrepreneurship in the public sector is different from the private sector.
Although neither can fail, the public consequences are very serious for the
public entrepreneur. It may be that the public entrepreneur should be
restricted from taking chances that could lead to any failures. Orange County
missed this lesson. The third lesson is that the public entrepreneur must be
prepared to face additional constraints in order to protect the public from poor
decision-making. This move to constrain is now occurring in California as the
State is examining ways to limit fiscal entrepreneurship.
The State has recently changed applicable California Government
Code sections for cash and investments. These Code section changes were
made as a direct result of the Orange County Bankruptcy. The primary
changes were made to California Government Code Sections 27130 to 21137
and 53600 to 53608. These groups of code sections deal with county treasury
oversight committees and investment of surplus funds. Table 2-1 summarizes
these two groups of code sections.
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The audit model suggested in Chapter 5 shows how audits can be
adjusted to address regulatory requirements. In the case of auditing cash and
investments for local agencies in California, the model needs to cover several
risk areas.
Table 2-1
California Government Code Sections
Chapter 4 - Article 1
Investment of Surplus
Section Section
53600. Local agency, definition. 53601.5 Investments; qualified
purchase agent.
53600.3 Prudent investor 53601.6
standard; investments
on behalf of local
agencies.
53600.5 Objectives; managing 53602.1
public funds.
53600.6 Legislative findings and 53607.
declarations; solvency
and creditworthiness.
53601. Authorized investments; 53608.
circumstances.
Prohibited
investments.
Repealed.
Delegation of duties to
treasurer; monthly
report.
Deposit of securities;
receipt, delegation of
authority.
53601.1 Investment in financial
futures or financial
option contracts.
(California Government Code, Sections 53600-53608)
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Table 2-1
California Government Code Sections
(continued)
Section
27130.
Article 6
County Treasury Oversight Committees
Legislative findings and
declarations.
Section
27132.4 Open meetings; Ralph
M. Brown Act.
27131. Establishment;
determinations of size
and membership.
27132. Membership; pool of
candidates.
27132.1 Member employment by
campaign contributors.
27132.2 Fundraising by
committee members for
county officials.
27133. Periodic investment
policy; preparation by
treasurer; committee
review and oversight.
27134. Periodic audits by
committee; article
compliance.
27135. Costs of compliance;
reimbursement.
27136. Withdrawal of funds
from county treasury
pool; requests;
evaluation; approval
criteria.
27132.3 Member fundraising. 27137. Day-to-day operations
and decisions;
committee
involvement.
(California Government Code, Sections 27130 - 27137)
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2.3 SPECIAL FINANCING DISTRICTS
The County of San Bernardino recently completed their $900 million
hospital (County of San Bernardino, 1998). The County financed this project
through its Special Financing Authority. Like many local governments, the
Special Financing Authority owns the facility and is leasing it back to the
County. The Special Financing Authority sold approximately $900 million
certificates of participation notes based upon the promise that the Hospital will
generate enough revenues to cover the debt. Since the Special Financing
Authority is a component unit of the County of San Bernardino, it is included in
the County’s financial statements. However, it should be noted that the
County is ultimately responsible for the debt if there is not enough revenue
generated by the Hospital. This financing scheme bypasses the need for the
County to obtain voter approval for general obligation bonds. This technique
has commonly been used by most local governments. This transaction is
complex and risky because it is based upon anticipated revenues from the
Hospital.
There are several concerns about this kind of entrepreneurial
transaction. What are the financial auditor’s responsibilities? What
procedures are users of audited financial statements expecting auditors to
perform? How should the financial auditor go about auditing this kind of
entrepreneurial transaction? To begin answering these questions, this study
first needs to understand special financing districts. The following discussion
provides some background on this type of public agency.
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The book, What’s So Special About Special Districts, is basically a
primer on special districts in California (Senate Local Government Committee,
1993). Special districts generate revenue from several sources. Some collect
fees to fund their activities, while others rely more heavily on property tax
revenues. Special districts have the same governing powers as other local
governments. They can enter into contracts, employ workers, and acquire
real property through purchase or eminent domain. Special Districts can also
issue debt, tax, levy assessments; and some can charge fees for their
services. Special districts, like other governments, can sue and be sued.
Special districts rarely have police powers. Police powers include the
ability to regulate behavior. Most special districts have single functions, are
non-enterprise type organizations, and are independent entities. Advantages
include services tailored to citizen demands, costs linked to benefits, and
responsiveness to constituents. Disadvantages include deficiencies because
of overlapping of jurisdictions with other government organizations, hindered
regional planning, and decreased accountability.
Decreased accountability is a major concern for financial auditors,
especially, when these public agencies rely heavily on generated revenues.
“Financing Infrastructure with Special Districts,” is what Porter (1987) studied.
Porter found that within the last 40 years, special districts have increased in
number from 8,299 to 28,719. Special districts now constitute approximately
one-third of all local government entities. Special districts are being employed
in innovative ways to solve mounting problems with the financing of
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infrastructures. The author provides the following statistics for special districts
nationwide: Total number of districts was 28,719; expenditures were $31
billion; revenues were $35 billion; and outstanding debt was $79 billion.
Porter emphasized that California has enabled the establishment of a
great variety of special districts, including those that provide water and sewer
service, and improvement districts that can be used for several purposes.
Special districts offer an opportunity for providing important services in areas
where the financial and/or administrative capacities of local governments are
constrained, for example, small municipalities not having qualified staff, limits
on amounts of debt, and limits on spending. Several state and local
governments have limits on debt, leaving communities with inadequate
financial resources to undertake capital improvements. Also, tax limitations
such as California's Proposition 13 may further limit local spending for public
facilities. Porter (1987) had these concerns regarding special districts: (1)
removal of power from local governments, (2) possible financial burdens and
risks, and (3) lack of political accountability.
Leigland (1989) reviewed some of the more controversial issues facing
special districts and the prominent role of the Census Bureau in the history of
research on this topic. One controversy is the growing reliance by regular
governments on special districts. Fragmented and uncoordinated delivery of
metropolitan services is another danger often cited. Despite controversies and
criticisms, public choice theorists maintain that use of multiple special districts
results in more efficiency and responsiveness in service delivery. Leigland is
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also concerned about less accountability and increased possibilities of
circumventing constitutional and statutory limits. His article also defines
subordinate entities as compared to independent entities. Subordinate entities
are those special districts that are closely related to a regular government
organization. The author found that subordinate entities annually averaged
$54.3 million in debt compared to $2.6 million for independent entities. In
addition, Leigland highlighted that 65.2 percent of all special districts had no
full-time or part-time employees, and many entities had no expenditures at all.
These studies emphasize that there are many uses for special districts.
Many of them are formed to ease the delivery of public services. In California,
most sizeable local government agencies use a public financing district. The
primary focus of these special financial districts is to raise funds, through the
offering of public debt, to construct public facilities. The anticipated revenues
to be generated by the facility usually secure the debt. If anticipated revenues
are not achieved, then the primary government and taxpaying constituents are
responsible to pay the debt. This financing scheme is a risky, complex
entrepreneurial activity. Porter (1987) and Leighland (1989) have identified
several risk areas associated with these kinds of transactions. Each special
financing district and its transactions are different. There is a need to develop
an audit model that can be adjusted for each district and its transactions. The
model proposed in Chapter 5 shows how an audit approach can be adjusted
for special financing districts.
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2.4 PERFORMANCE MEASUREMENT SYSTEM
2.4.1 Government Financial Environment
The governmental financial environment is changing more rapidly than
it ever has in the past. Many analysts and researchers often cite several
reasons for the changes at all levels of government. One reason is the global
economy. Our nation is competing more than ever in world markets. More of
our domestic consumer products are now coming from other countries.
Several researchers have emphasized that we must reduce our government
overhead to be competitive in this new global economy.
Another often cited reason for changes in governmental organizations
is that taxpayers are at their limits in paying taxes, fees, and user charges.
Over the last decade, tax rates have been reduced, property taxes have been
limited, and user fees have been questioned. However, governmental
services are still demanded and in many areas, are increasing. In addition, it
has been politically palatable for aspiring politicians and policymakers to say
they will further reduce taxes and governmental spending.
A third reason for rapid changes in government organizations is policy
makers and constituents are demanding more accountability. Many of them
are saying, "government organizations should be operating more like
businesses." In fact, the latest fad is "reinventing" public organizations. To
deal with this trend, both our federal and state governments have enacted
laws designed to reinvent themselves.
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This rapidly changing government financial environment is a challenge
for governmental financial management. Government financial management
professionals must, more than ever, have solid control over operations; their
work must be timely, accurate, and meaningful. Our state government and
several local governments are reinventing themselves. Researchers are
analyzing various areas, including organizational culture, and are developing
new theories and approaches for managing organizations. These agencies
are using strategic planning, total quality management, performance
budgeting, capital budgeting, and other approaches in developing systems to
effectively and efficiently translate policy into operations.
2.4.2 Background on Performance Measures
Wholey and Hatry (1992) reported on a problem with establishing
performance standards and measurements. These authors said performance
indicators are a major problem in performance evaluations. They reasoned
there are several interest groups that have different goals for the same
program, and most public services have multiple outcome and quality
dimensions; therefore, an appropriate performance monitoring system will
require multiple indicators. To reduce the number of indicators and
discourage "creaming," there should be proper identification of important
quality and outcome dimensions. Wholey defined "creaming" as selecting
those measures which enhance the performance of the agency or program.
Other groups and authors reported these same problems when identifying
program measurements.
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The California Department of Consumer Affairs (1994) reported this
same problem but identified some solutions. Their reports suggested that
organizations should understand or establish organizational missions, goals,
and objectives. These missions, goals, and objectives should be then
quantified into measurements. The measurements can be further identified as
input, output, and outcome measurements. Input measures are resource use
measures. Output measures are efficiency measures that relate to unit costs
of services. Outcome measures are referred to as effectiveness measures.
To objectively measure the performance of a program, a well-balanced
measurement system will be needed.
Transaction costs are one of the problems with establishing
measurement systems for programs or agencies. It is costly and time-
consuming to establish reliable management control systems to maintain data.
In fact, a recent congressional report (Congress of the United States, 1993)
and Hill's (1995) article described the cost and time problems associated with
implementation of performance budgeting systems. However, both the report
and the article emphasized that it appears these systems are beneficial.
Further studies and analyses are needed to examine and verify whether the
benefits do, in fact, outweigh the costs.
Indirect transaction costs not often analyzed or discussed are ones
associated with alienation of staff because management is demanding another
system. It seems that many agencies have tried various management
techniques to improve services and the productivity of governmental services.
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The latest idea in developing systems is to capture data that will supposedly
better measure performance in usable, understandable measures. It takes
planning, time, and substantial involvement of management and policy makers
to change and reshape major changes within the organizational culture.
Bowditch and Buono (1990) defined organizational culture as a shared pattern
of beliefs, assumptions, and expectations held by organizational members.
Gonring (1992) discussed how important communication is in establishing or
reshaping organizational culture; he felt management can determine the pace
of change by understanding the work force and how it has been historically
managed. According to Schein (1985), members should understand the
mission, strategy, and organizational goals; have the means to adapt; and
have effective measurement and correction systems.
Perhaps, one way to analyze and understand transaction costs is
Francis and Borwick's (1990) equivalency factor. The equivalency factor can
be used in conjunction with performance budgeting as a means to measure
and compare different activities of government. Under the current model of
budgeting by department, fund, and line-item, there is no consistently used
rational methodology to allocate revenues to the costs of providing services or
public goods. Political decision-making dominates in allocating resources
among different agencies and activities. Considering today's governmental
financial environment, it is becoming increasingly necessary to have a rational
method dominate the budget process rather than a politically dominated
system.
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The City of Tracy identified equivalency factors as equivalent dwelling
units (EDUs) (Francis and Borwick, 1990). Tracy’s managers calculated total
EDUs by the number of residents and persons employed divided by persons
per dwelling unit. Total EDUs were divided into a numerator, for example,
expenditures. This measure then would provide the decision-maker with a
common-based factor to compare various services among competing city
departments. The authors stressed this method can be used for limited
performance analysis without full performance measurement features. The
shortcoming of the EDU as a measure of productivity is that it does not relate
to the specific demands for individual programs or to their specific outputs.
Another way to reduce transaction costs may be to make performance
measures part of the annual audited financial report. The Governmental
Accounting Standards Board (GASB, 1992) has recently issued an exposure
document advocating this suggestion. If adopted, performance measures
could be part of the comprehensive annual financial report. By having
performance measures as part of this report, transaction costs may be
minimized because organizations will already have an auditor reviewing the
organization. The additional costs of auditing performance measures should
be minimal because it would not take the financial auditor much more effort to
review the management controls that maintain these measures. One
important factor in determining the costs associated with the financial auditor
reviewing performance measures is how much assurance will be necessary on
this additional information? Another concern is over whether large transaction
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costs still will exist because of the need for new administrative systems to
maintain input, output, and outcome data.
Other transaction costs could come from the auditors themselves.
Some researchers in this area have found that not all audits are performed in
accordance with standards. Hepp and Mengel (1992) discuss in their article
the high rate of substandard audits. Berry, Harwood, and Katz (1987) discuss
in their article the high rate of false sign-offs on the audit program. In Wheat's
(1991, p. 392) article, he connects program evaluation to an activist auditor.
An activist auditor is an auditor who has over 30 years of experience and
understands the nuances and differences of the government agency.
2.4.3 Background on Performance Budgeting
Governments are downsizing; however, service levels are still being
demanded, and as a result, resources must be effectively stretched to meet
the demands. To maintain control over limited resources, government
financial management must be fully integrated; e.g., a government must
allocate its resources to expected services and programs and receive better
feedback on those services and programs to help allocate existing and future
resources.
Several years ago, Caiden (1981) emphasized that traditional methods
of allocating resources through budgeting were no longer appropriate. She
believed that current budget theory and practice lag behind operational
requirements. She thought we now have to work on a different assumption;
namely, that public resources are finite and public needs infinite. Caiden also
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thought that performance budgeting was "fertile ground." However, new
techniques have been receiving reluctant acceptance. She believes the aim of
budgeting is seen as the maximization of societal return for public
expenditures. Caiden contrasts procedural rationality with incrementalism and
political dynamics. Obviously, she believes that more rationality should be
involved in the budget process rather than politics to solve today's
governmental dynamics. She also believes there is no reason why improved
budget techniques should not inform, clarify, and strengthen political and
financial decision-making. In short, budget processes cannot be conceived as
a set of fixed techniques that remain in place irrespective of what is happening
around them.
Organizations need to be more dynamic, and individuals need to
routinely depart from the established culture to foster a proactive organization.
Organizational culture changes over the life cycle of the organization.
Effective leaders and managers recognize that the organizational culture
should change when the organization moves from founding and early growth,
to mid-life, and finally, into maturity and declining. Schein (1985) believes that
leaders and managers use different methods to create the appropriate culture.
Caiden's (1981) idea about using rationality in the budget process is not
new. Lowe, Cope, and Cunningham (1954) suggested municipalities use
performance budgeting and unit cost accounting. The methodology they
emphasized was based upon rationale, performance, and operational
analyses to allocate resources. Most of these kinds of budgeting methods are
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associated with program budgeting. There have been several types of
program budgeting methods. Those methods included McNamara's Planning-
Programming-Budgeting System, Zero-Based Budgeting, and more recently,
performance budgeting.
Several organizations have implemented a performance budgeting
system or some form of this system. The State of California 1993/94 budget
included performance budgeting techniques in four state departments
(California Department of Consumer Affairs, 1994). The Department of
Consumer Affairs (DCA) was selected to participate in the performance-based
budgeting pilot project. DCA management recognized the importance of
developing a performance measurement system for the budgeting process. A
balanced set of measures consisting of outcome, intermediate outcome, input,
output, and efficiency measures must be developed. Outcome measures
(sometimes referred to as effectiveness measures) must be balanced against
input (resource uses) and efficiency measures (the unit cost of services)
Dell'Agostino (1993) reviewed the above four departments’
implementation of performance budgeting. He felt that the California
performance budgeting process still had merit and was worth pilot testing;
however, it was too early to know how well this budgeting process was
working. Performance budgeting differs from the traditional approach to
budgeting in that it focuses on outcomes rather than inputs or processes when
deciding how to allocate resources. Dell'Agostino found that other states have
experienced mixed results from performance budgeting; it did provide helpful
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budgetary decision-making information but did not fundamentally change the
budget process. Performance budgeting was not the “final arbiter" of funding
decisions given the political nature of the budget process because of the
reluctance of executives to change their budget process. Perhaps, if the
organization's leaders had shared patterns of beliefs, assumptions, and
expectations, the budget process would have been perceived differently. A
change from budget decision-making based on policy and political
considerations to one based on performance can give managers greater
decision-making flexibility.
Dell'Agostino also found that performance budgeting did not
fundamentally change the budget process in other states. Time, resources,
and data constraints limited the use of performance information by the
legislative and executive branches. Also, legislative and executive budget
decision-makers were dissatisfied with, and questioned the reliability of,
performance measures. A final reason given was performance budgeting
complicated the budget process by highlighting trade-offs among programs
competing for limited resources.
Minnesota is another state implementing a performance budgeting
system. King's (pp. 7-10, 1995) article describes their performance-based
budget and reporting system with a focus on effectiveness and accountability
of state services. The new performance budget and reporting system follows
three principles:
• Government must be driven by the public's goals and mission rather
than government's rules and regulations;
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• taxpayer will pay for results rather than efforts; and
• governments must be able to measure and communicate progress
toward both goals and results.
Minnesota decided to implement the new system all at one time rather than
incrementally because a phased approach might subject different agencies to
different rules. The article also said that the legislative auditor would evaluate
agency performance reports for reasonableness and validity of information
and data. The budget process also included capital budget items. The article
emphasized that millions of dollars were saved through use of the new
process, and millions more were being spent more efficiently than when they
used past traditional approaches for capital project allocation.
The City of Milwaukee is another municipality implementing a
performance budgeting process. Kinney's (1995) analysis described the
implementation issues of incorporating Milwaukee's strategic plan into their
budget. The methodology is similar to implementing a performance budgeting
system. Elements of their system include a citywide strategic plan,
departmental strategic plans, outcome indicators, departmental budget
requests, departmental budget allocations, budget review, and executive
budget review. The author stressed the most persuasive argument for
pursuing this method was either implicitly or explicitly related to results, and
establishing this connection up front was best.
The City of Sunnyvale's performance budgeting system has been
implemented since 1979 (Chan, 1994). Officials there manage a $149 million
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municipal corporation on three essential business principles: long-range
planning, performance budgeting, and performance auditing. The budget is
service-oriented and is designed to spell out both quantity and quality of public
services; it extensively uses a cost-accounting system, which captures the
cost involved in every unit of service.
2.4.4 Preliminary Conclusions
Implementing a performance budgeting system is a major
organizational cultural change. As noted by Gonring (1992), the professional
must communicate that there is a genuine commitment by management to
make a change. Understanding the nature of the work force and how it has
been historically managed will help in determining the pace for change.
Changing shared ideas in a new culture depends on the pace. To more easily
adapt, Schein (1985) suggests members should understand the mission,
strategy, and organizational goals; have the means to adapt; and have
effective measurement and correction systems.
Evaluating the performance of key management staff is one way of
measuring the success of the program. The reason the City of Sunnyvale has
a successful program is economic incentives are offered to management staff.
To motivate key staff in effectively implementing a performance budgeting
system, several organizations have used additional economic incentives, for
example, bonuses.
The use of a performance measurement system is a complex,
entrepreneurial activity. An effective system is complex because it involves
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internal and external factors. The internal factors are allocating funds and
resources among departments based upon performance. The external factors
are projecting regional and national economies that affect the government,
and projecting inter-governmental operations. The projections in this area
could be both for intergovernmental revenues and expenditures. A
performance system is entrepreneurial because the agency is taking risks in
the allocation of its resources based upon performance. The introduction of a
performance incentive system within government is innovative and business
like. Most governments incrementally allocate funds and resources based
upon usage from the prior year.
What are the financial auditor’s responsibilities for auditing performance
measurement systems? Performance auditors already review performance
measures and other program evaluation studies. Why should financial
auditors also be concerned about auditing performance measurement
systems? One argument is that the new reporting model may require them to
include measures in a comprehensive annual financial report. The GASB
issued a “preliminary views” document entitled, “Service Efforts and
Accomplishment Reporting” (GASB, 1992). The document is seeking
interested parties' views on establishing reporting standards for service efforts
and accomplishments (SEA) data. The Board feels that in addition to standard
financial information, SEA measures will be very helpful to policy makers,
management, and constituents. The document explains different types of SEA
measures and how an organization might go about recording, maintaining, and
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reporting the information. The major reason for this information is increased
accountability; however, the document further explains the evolution of
financial reporting. SEA measures provide information that is useful in
assessing whether an entity's agencies, departments, programs, or services
are achieving their goals and objectives economically, efficiently, and
effectively.
Another reason why financial auditors should be concerned about
performance systems is they have to report on budgeted data. Generally,
performance systems are tied to a budgeting system. Another reason is
resources may be ineffectively used, causing the government to become more
financially unstable. The financial auditor would then be required to report on
the performance system. Chapter 5 suggests an audit framework that can be
used to audit a performance measurement system that is part of the financial
reporting model identified in Chapter 3. This audit model can be adjusted to
address the unique characteristics of different performance measurement
systems.
Table 2-2
State and Local Financial Auditors’ Concerns
Over a Performance Measurement System
• Proposed requirement of Governmental Accounting Standards Board
• Part of budget system
• The system affects financial position
• Complex entrepreneurial activities
• Government Auditing Standards require understanding major
administrative systems (See Chapter 3)
(Original table)
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2.5 CONCLUSION AND TRANSITION TO CHAPTER 3
This Chapter has provided examples of California state and local
governments’ entrepreneurial activities. The Orange County Bankruptcy,
special financing districts, and performance measurement systems all involve
the risky use of public resources in the creation of value for the citizenry.
The current state and local government audit model does not address all of
the risks associated with entrepreneurial activities. The current model also
does not address entrepreneurial activities in public organizations. Most
governments are developing creative solutions in delivery services. A financial
audit model needs to be developed to keep pace with this new government
paradigm. A financial audit model has been proposed in Chapter 5 that can
be adjusted for each of the entrepreneurial activities described in this chapter.
This study now focuses on literature that describes the current state
and local government audit model. Therefore, the next chapter describes the
salient points of GAO’s auditing standards, the AICPA auditing standards, and
the OMB A-133 auditing standards. In addition, it is important to analyze the
proposed new financial reporting model because it impacts related auditing
standards.
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CHAPTER 3
CURRENT STATE AND LOCAL GOVERNMENT AUDIT STANDARDS
AND REPORTING MODELS
3.1 INTRODUCTION
State and local government agencies are big organizations. Local
agencies, in California, are often the largest organizations in their
communities. Auditing larger organizations, whether public or private, is more
difficult than auditing smaller ones. Larger organizations are riskier to audit
because they usually have more transactions, multiple products and services,
and decentralized controls systems. In addition, the concepts of accountability
and stewardship of public resources inherently make local government audits
more difficult. This chapter summarizes existing state and local auditing
standards; it also summarizes the Governmental Accounting Standards Board
(GASB) proposed new state and local reporting model. Finally, the Chapter
relates these auditing and reporting models to entrepreneurial transactions.
3.2 GENERAL ACCOUNTING OFFICE (GAO) AUDITING STANDARDS
Government Auditing Standards issued by the Comptroller General of
the United States provide standards for audits of government organizations,
programs, activities, and functions, and of government assistance received by
contractors, nonprofit organizations, and other non-government organizations.
These standards, often referred to as generally accepted government auditing
standards (GAGAS), are to be followed by auditors and audit organizations
when required by law, regulation, agreement, contract, or policy. The
standards pertain to auditors’ professional qualifications, the quality of audit
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effort, and the characteristics of professional and meaningful audit reports
(Bowsher, 1994).
3.2.1 Applicability
The Single Audit Act of 1996 (104th Congress, 1996) requires that
GAGAS be followed in audits of state and local government organizations
receiving federal financial assistance. Other federal policies and regulations,
such as Office of Management and Budget (OMB) Circular A-133 (1996),
require that these standards be followed in audits of institutions of higher
education and other nonprofit organizations that receive federal financial
assistance. The standards in this document are recommended for use by
state and local government auditors and public accountants in audits of state
and local government organizations, programs, activities, and functions.
Several state and local audit organizations have officially adopted GAGAS.
3.2.2 Accountability
The system of managing public programs today rests on an elaborate
structure of relationships among all levels of government. The concept of
accountability is inherent in the governing processes of this nation. The need
for accountability has caused a demand for more information about
government activities. Public officials, legislators, and citizens should know
that resources are used properly and in accordance with laws and regulations.
The GAGAS help to provide accountability and to assist public officials and
employees in carrying out their responsibilities. GAGAS are more than the
codification of current practices. These Standards include concepts and audit
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areas that are still evolving and are vital to the accountability objectives sought
in auditing government organizations and their programs and services.
Bowsher (1994) believes that auditing government reporting is an essential
element of public control and accountability. Auditing provides credibility to
the information reported by or obtained from management through objectively
acquiring and evaluating evidence.
GAGAS provide guidance for financial and financial-related audits and
performance audits. This study analyzes the current financial audit model(s)
for state and local financial audits. Therefore, financial and financial-related
parts of GAGAS are reviewed and analyzed. Table 3-1 lists applicable
chapters for financial and financial-related audits. These chapters make up
part of the current auditing standards that comprise the state and local
financial audit model.
Chapter 3 of GAGAS prescribes general standards for conducting
financial and performance audits. These general standards cover
qualifications of staff, the auditor’s independence, the exercise of due
professional care in conducting the audit and in preparing related reports, and
the audit organization’s quality control systems and review. GAGAS, Chapter
4, prescribes standards of fieldwork for financial and financial-related audits.
Table 3-2 shows standards of fieldwork included in GAGAS (GAO, 1994).
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Table 3-1
Government Auditing Standards
Financial Audits
Chapter 1 • Purpose
Introduction • Applicability
• Accountability
• Basic Premises
• Auditors’ Responsibilities
• Procurement of Audit Services
Chapter 2
• Purpose
Types of Government Audits • Financial Audits
• Performance Audits
• Other Activities of an Audit Organization
Chapter 3
• Purpose
General Standards • Qualifications
• Independence
• Due Professional Care
• Quality Control
Chapter 4
• Purpose
Field Work Standards for • Relation to AICPA Standards
Financial Audits • Planning
• Irregularities, Illegal Acts, and Other
Noncompliance
• Internal Controls
• Working Papers
• Financial Related Audits
Chapter 5
• Purpose
Reporting Standards for • Relation to AICPA Standards
Financial Audits
• Communication with Audit Committees
or Other Responsible Individuals
• Reporting Compliance With Generally
Accepted Government Auditing
Standards
• Reporting on Compliance With Laws and
Regulations and on Internal Controls
• Privileged and Confidential Information
• Report Distribution
• Financial Related Audits
(Bowsher, 1994, pp. 2-3)
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Table 3-2
Generally Accepted Government Auditing Standards
Standards of Fieldwork
• The work is adequately planned and supervised
• Obtain an understanding of the internal control structure
• Obtain competent evidential matter
• Audit follow-up
• Noncompliance other than illegal acts
• Working papers standards
• Materiality
• Irregularities and illegal acts
(Bowsher, 1994)
These chapters emphasized the basic audit approach of understanding
the internal control structure and how it safeguards the organization’s assets.
The chapters also emphasize the auditor’s responsibilities in determining
whether the government organization being audited is in compliance with laws
and regulations. Both of these elements are used in this study’s proposed
audit model in Chapter 5. Chapters 3 and 4 of GAGAS do not discuss any
risks associated with entrepreneurial activities. A logical area of addressing
entrepreneurial risk activity in a public organization should be during the
understanding of the internal control structure phase of the audit.
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GAGAS (Bowsher, 1994), Chapter 4, sections 4.21 to 4.30, describe
and discuss in detail aspects of the organization’s internal control structure.
GAGAS and the AICPA standards (1998) require the following.
Auditors should obtain a sufficient understanding of internal
controls to plan the audit and determine the nature, timing, and
extent of tests to be performed.
Four aspects of internal controls shown in Table 3-3 are important to the
judgments made by auditors about audit risk (Bowsher, 1994).
Table 3-3
Aspects of Internal Control
• Control Environment
• Safeguarding Controls
• Controls Over Compliance
• Control Risk Assessment
(Bowsher, 1994)
An auditor’s judgment about the control environment includes the
organization’s actual control procedures and testing of the procedures.
Internal control over the safeguarding of assets is concerned with the
unauthorized acquisition, use, or disposition of the entity’s assets that could
have a material effect on the financial statements. Safeguarding controls are
not limited to preventing or detecting misappropriations of assets. Such
control activities include controls to permit acquisition, use, or disposition of
assets only in accordance with management’s general or specific
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authorizations, including compliance with established policies and procedures
for such acquisition, use, or disposition.
Controls over compliance should provide reasonable assurance that the
financial statements are free of material misstatements resulting from
violations of laws and regulations. To meet this requirement, auditors should
have an understanding of internal controls relevant to financial statements’
assertions affected by those laws and regulations. In addition, auditors should
design tests to properly evaluate internal controls over these administrative
requirements.
The auditor assesses control risk based upon his or her understanding
and testing of the internal control environment. If the auditor assesses control
risk below maximum risk, then GAGAS require that the working papers show
evidence to support this conclusion.
The understanding and testing of the internal control environment does
not specifically address auditing entrepreneurial activity. The auditing of
complex, risky transactions can be done in several stages during the audit.
For example, to audit Sacramento County’s guarantee on $26.6 million for
bonds for the baseball stadium discussed in Chapter 2, an auditor can
examine documents and validate authorization and balances during year-end
testing procedures rather than the internal control phase of the audit. The
important point is that the auditor recognizes during any phase of the audit that
the transaction is a complex entrepreneurial activity. In addition, these
transactions present unique risk factors that should require appropriate
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responses from the auditor. Chapter 5 proposes an audit model that
incorporates entrepreneurial risk factors during a local government financial
audit. The chapter further suggests appropriate auditor responses to risk
factors possibly present from the three examples of entrepreneurial activities
given in Chapter 2.
3.3 AICPA AUDITING GUIDE
Government accounting and auditing are unique in many respects.
Government’s multiple-fund structure, extensive reporting requirements, basis
of accounting, and budgetary and other legal compliance requirements
present an environment that is significantly different from that encountered in
the audit of a commercial or not-for-profit organization (AICPA, 1998).
A financial audit of a state and local government may be conducted
under three different levels of audit standards or requirements (AICPA, 1998)
as noted below:
• Generally accepted auditing standards (GAAS);
• The standards applicable to financial statement audits contained in the
1994 revision to Government Auditing Standards (often called the
Yellow Book, are generally accepted government auditing standards, or
GAGAS) issued by the Comptroller General of the United States; or
• The additional requirements of the Single Audit Act Amendments of
1996 (the Single Audit Act).
The relationship of these three levels of auditing standards is illustrated
in Figure 3-1.
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Figure 3-1
Levels of Auditing Standards
GAAS GAGAS
Single Audit Act
(Original figure)
The AICPA Auditing Guide incorporates all three levels. Collectively,
they establish the financial auditing model for state and local government
financial audits. Figure 3-1 illustrates that GAAS establish most of the
standards for financial statement audits. GAGAS require additional general
and fieldwork standards beyond those required in an audit in accordance with
GAAS on audit follow-up and working papers. In addition, GAGAS prescribe
as part of the financial statement audit, additional reporting requirements
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beyond those in GAAS that are related to compliance. The Single Audit Act
prescribes specific audit procedures to determine if federal programs are
being properly operated.
GAGAS’ additional general standards provide guidance on auditor
qualifications, independence, due professional care, and quality control
systems within the auditing organizations. The additional fieldwork standards
are discussed in section 3-2. Figure 3-1 shows that the Single Audit Act has
additional standards for state and local financial statement audits. Most of
these standards relate to compliance with laws and regulations. Financial
statement auditors must determine whether noncompliance with federal laws
and regulations affects the government organization’s financial statements.
There are over 86,000 state and local governmental units in the United
States. These include the following (AICPA, 1998):
• States
• Counties
• Cities, towns, and villages
• School districts
• Municipal utility districts
• Public benefit corporations and authorities
• Public employee retirement systems (PERS)
• Governmental colleges and universities
• Governmental hospitals and other providers of health care services
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• Other special purpose districts and authorities, established to
provide services such as sanitation, or to manage enterprises such
as toll roads and airports
The purpose of the AICPA Auditing Guide is to provide guidance for
accounting, auditing, and reporting on the financial statements of state and
local governmental entities. The guide is based on existing pronouncements
of authoritative standard-setting boards, as well as other sources of generally
accepted accounting principles (GAAP) and auditing standards.
There are several unique aspects when auditing state and local
government organizations. Government organizations manage public funds,
which, by their nature, require public accountability. Public funds and their
operations generate public interest in the accountability for those funds. There
may be qualitative issues, such as controversial new revenue sources or
projects, or job performance issues, that an auditor may need to address but
that may not be part of an audit of the financial statements of non
governmental organizations (AICPA, 1998). In addition, resources are
required to be administered in accordance with laws and regulations for which
noncompliance could have a material effect on the financial statements.
Because of these unique aspects, GAGAS notes that auditors may set lower
materiality levels in state and local financial statement audits. Lower
materiality levels increase audit procedures because there is higher assessed
audit risk.
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3.3.1 The Development of the Audit Guide
The governmental financial environment is changing more rapidly than
it ever has in the past. Many analysts and researchers cite several reasons
for changes at all levels of government. One reason often cited is the global
economy. Our nation is competing more than ever in world markets. More of
our domestic consumer products are now coming from other countries.
Several researchers have emphasized that we must reduce our government
overhead to be competitive in this new global economy.
Another reason for changes in governmental organizations often cited
is taxpayers are at their limits of paying taxes, fees, and user charges. Over
the last decade, tax rates have been reduced, property taxes have been
limited, and user fees have been questioned. However, governmental
services are still demanded and, in many areas, are increasing. In addition, it
has been politically palatable for aspiring politicians and policy makers to say
they will further reduce taxes and governmental spending. A third reason for
rapid changes in government organizations is policy makers and constituents
are demanding more accountability. Many of them are saying, "government
organizations should be operating more like businesses." In fact, one current
fad is "reinventing" public administration. To deal with this trend, both our
federal and state governments have enacted laws designed to reinvent
themselves.
This rapidly changing government environment is a challenge for
governmental financial management. Government financial management
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professionals must, more than ever, have solid control over operations. Their
work must be timely, accurate, and meaningful. Our State government and
several local governments are reinventing themselves. Researchers are
developing new theories and approaches for managing organizations.
This study is suggesting an audit approach that is grounded in
administrative theory that will keep pace with the recent entrepreneurial
paradigm. Financial auditing is another form of program evaluation. Program
evaluation has been a discipline since administration began. Most articles
discuss different methodological approaches in program evaluation. For
example, Clayton (1980) discussed how an evaluator needed to understand
the program and its objectives before evaluating it. He also provided a
program evaluation model. Clayton also discussed a pragmatic approach to
developing "organizational accounting systems" that meet managerial needs
and provides guidance for designing them. The author defines organizational
indicators used in accounting systems as direct or proximate measures that
can be used to monitor changes over time in the conditions of an organization
that are important to its performance and health. He suggested a
management data base comprised of a carefully selected combination of
reactive and unobtrusive measures that serve as indicators of an
organization's performance and health. Parameters that help design an
accounting system are acceptability, subjectivity, multiple uses, administrative
simplicity, precision, comprehensiveness, continuity, and specificity.
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The AICPA Audit Guide, Audits of State and Local Governmental Units
(ASLGU), has undergone several changes in response to the evolution of
government financial environment. The financial standard setting bodies are
striving to establish measures, similar to the ones suggested by Clayton
(1980), that meet user needs. AICPA Statements of Positions (SOP)
(Johnston and Agee, 1996) substantially amended the first two versions of
ASLGU, 1974 and 1986. The AICPA issued a completely rewritten ASLGU in
1994 and has annually reissued it with “conforming changes” each May; the
latest version was issued on May 1, 1998.
The current ASLGU is the most comprehensive ever. Topics
addressed include: (1) basics of governmental accounting, financial reporting,
and auditing; (2) audit-related aspects of special purpose governments; (3)
jointly signed audit reports and opinions on “popular reports;” and (4)
performing audit procedures and reporting on single audits (Johnston and
Agee, 1996).
ASLGU commemorated its 25th year in 1999. Originally effective for
fiscal years beginning January 1, 1974, the first ASLGU was 157 pages.
Governmental financial reporting and auditing have grown more complex in
the ensuing years, and ASLGU’s successive releases chronicle these changes
(Johnston and Agee, 1996). The 1994 version has 438 pages, which include
19 chapters and 15 appendices. The AICPA has released three versions of
ASLGU in multiple separate printings. A chronology of ASLGU releases is
summarized in Table 3-4.
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Table 3-4
Editions of ASLGU
1974
1975
1978
1981
1986
1989
1992
Original version, an Industry Audit Guide (2 Appendices)
Original version including
SOP 75-3, - Accrual of Revenues and
Expenditures by State and Local
Governmental Units
Original version including
SOP 75-3
SOP 77-2, - Accounting for Interfund
Transfers of State and Local
Governmental Units
‘Third Edition." Original version including
SOP 75-3
SOP 77-2
SOP 78-7, - Financial Accounting and
Reporting by Hospitals Operated
by a Governmental Unit
SOP 80-2, - Accounting and Financial
Reporting by Governmental Units
“Revised Edition,” an Audit and Accounting Guide, superseded the
1974 version (6 Appendices)
“Fifth Edition” including
SOP 89-6 - Auditors’ Reports in Audits of
(7 Appendices) State and Local Governmental
Units
ASLGU with Conforming Changes as of May 1, 1992 (gray cover)
including
SOP 90-9, - The Auditor’s Consideration of
the Internal Control Structure
Used in Administering Federal
Financial Assistance Programs
Under the Single Audit Act
(9 Appendices)
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Table 3-4
Editions of ASLGU
(Continued)
1993 ASLGU with Conforming Changes as of May 1,1993 (gray cover)
including
SOP 92-7, - Audits of State and Local
Governmental Entities Receiving
Federal Financial Assistance
(10 Appendices)
1994 ASLGU (gray cover), an Audit and Accounting Guide, supersedes
the 1986 “Revised Edition” (11 Appendices)
1995 ASLGU with Conforming Changes as of May 1, 1995 (gray cover)
(12 Appendices)
1998 ASLGU with Conforming Changes as of May 1, 1998 (gray cover)
(15 Appendices)
(Johnston and Agee, 1996, p. 25)
3.3.2 1998 ASLGU
The ASLGU is organized as follows:
• Part I, “Introduction,” includes Chapters 1 -5; it discusses the financial
reporting entity and fund structure. This discussion takes into
consideration the fact that governmental units become involved in a
variety of ventures, which may or may not be part of the audited
entity. It also provides guidance on planning the audit, the auditor’s
understanding of the entity’s internal control, and compliance testing.
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• Part II, ‘The State and Local Government Audit—Governmental
Funds and Account Groups,” includes Chapters 6-12; it addresses
the budget, cash and investments, receivables and revenues,
expenditures and related liabilities, capital expenditures and related
fund and account group activity, debt and debt service, and inter
fund transactions and fund equity.
• Part III, T h e State and Local Government Audit—Proprietary and
Fiduciary Funds,” Chapters 13 and 14, addresses enterprise funds,
internal service funds, expendable trust funds, non-expendable trust
funds, pension trust funds and agency funds.
• Part IV, “Other Governmental Audit Engagements," Chapters 15 and
16, highlights special governmental units and state governments.
• Part V, “Concluding the Audit,” Chapter 17, discusses
representations from management, related party transactions, going
concern considerations, commitments and contingencies,
subsequent events, and analytical procedures.
• Part VI, “Auditor’s Reports,” Chapters 18 and 19, discusses auditor’s
reports on basic or general-purpose financial statements (GPFS) in
association with financial statements included in official statements.
(AICPA, 1998)
Table 3-5 summarizes the table of contents of the earliest ASLGU and
the most recent ASLGU. There has been a dramatic increase in terms of
guidance on how to audit state and local financial statements since 1974. The
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guidance reflects the numerous changes in reporting standards primarily
issued by GASB, generally accepted auditing standards issued by the AICPA,
generally accepted government auditing standards issued by the GAO, and
the Single Audit Act.
It is clear that ASLGU has had many changes since its inception.
However, most of these changes reflect the constantly changing standards in
government financial reporting and auditing. One change was the
Government Accounting Standards Board was established in April 1984
(GASB, COD, 1999). Another change was the federal Single Audit Act
became law in 1985 (OMB, 1997). In addition, there were two revisions to
Government Auditing Standards in 1988 and 1994. The AICPA has also
issued numerous auditing standards since 1974. Basically, ASLGU has been
keeping pace with all of these changes in standards. The nature of most of
these changes has been an improvement in reporting and auditing significant
accounts and transactions.
For example, municipalities in California have been charged with
investing their available funds. Investment transactions were reported in the
financial statements at amortized costs. Recently, GASB Statement No. 31
(GASB, 1997) was issued to require state and local government organizations
to report investment transactions at fair value. GASB Statement No. 31 also
had several additional disclosure requirements for the financial statements.
This new standard causes significant revisions to ASLGU and represents one
example of the types of changes made since 1974.
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Table 3-5
The Earliest and Most Recent ASLGUs
1974
Characteristics of Governmental Accounting
Chapter
1 Growth and Development of Governmental Accounting
2 Accounting Principles and Concepts
3 Budgeting Practices and Procedures
Auditing of Governmental Units
4 Audit Concepts
5 Auditing Procedures
Financial Statements and Auditors’ Reports
6 Presentation of Financial Statements
7 The Independent Auditor’s Report
Appendix
A Principles of Governmental Accounting and Reporting
B Applicability of Professional Pronouncements to Financial
Statements of Governmental Units
1994
(With 1998 Conforming Changes)
Introduction
Chapter
1 Overview
2 The Financial Reporting Entity and Fund Structure
3 Planning the Audit
4 Internal Control Structure
5 Testing and Reporting on Compliance with Laws and Regulations
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Table 3-5
The Earliest and Most Recent ASLGUs
(Continued)
1994
(With 1998 Conforming Changes)
(Continued)
The State and Local Government Audit
- Governmental Funds and Account Groups
6 The Budget
7 Cash and Investments
8 Receivables and Revenues
9 Expenditures and Related Liabilities
10 Capital Expenditures and Related Fund and Account Group Activity
11 Debt and Debt Service
12 Interfund Transfers and Fund Equity
- Proprietary and Fiduciary Funds
13 Proprietary Fund Types
14 Fiduciary Funds
Other Governmental Audit Considerations
15 Special Governmental Units
16 State Governments
Concluding the Audit
17 Concluding the Audit
Auditor’s Reports
18 Auditor’s Reports on Basic or General-Purpose Financial Statements
19 Association With Financial Statements Included in Official Statements
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Table 3-5
The Earliest and Most Recent ASLGUs
(Continued)
1994
(With 1998 Conforming Changes)
(Continued)
Appendix
A Illustrative Auditor’s Reports
B Illustrative Internal Control Structure Questions - State and Local
Governmental Units
C The Single Audit Act of 1984
D Questions and Answers on the Single Audit Process of OMB Circular A-
128. Issued by the Office of Management and Budget, November 1987
E OMB Circulars That Address Management of Federal Assistance
F The Common Rule — Uniform Administrative Requirements for Grants
and Cooperative Agreements to State and Local Governments. Issued
by the Office of Management and Budget, March 1988
G Key Events in the History of Auditing Federal Programs
H Single Audit Literature
I Federal quality Control Procedures
J Acronyms and Abbreviations
K Interpretation of SAS No. 41, Working Papers. Titled, “Providing Access
to or Photocopies of Working Papers to a Regulator”
L Statement of Position 98-2, Accounting for Costs of Activities of Not-for-
Profit Organizations and State and Local Governmental Entities That
Include Fund Raising
M Statement of Position 98-3, Audits of States. Local Governments and
Not-for-Profit Organizations Receiving Federal Awards
N Illustrative Request to Actuary for Confirmation of GASB Pension
Information
O Schedule of Changes Made to Audits of State and Local Governmental
Units
(Johnston and Agee, 1996, pp. 26 & 27)
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ASLGU changes have not directly reflected the changes happening
within the government industry environment, such as reduced funding,
privatization, competition, and state and federal mandates. These and other
changes have caused government organizations to become more
entrepreneurial. Many state and local government organizations in California
have become increasingly entrepreneurial over the last 10 years. ASLGU has
not appropriately addressed this important industry change. In Part I, ASLGU
briefly mentions the need to address changes in the operating environment.
The Guide also “dances” around entrepreneurial risk in its guidance for
internal controls.
3.3.3 Internal Control Environment
ASLGU emphasizes that the auditor is required to obtain an
understanding of each of the five components of internal controls.
1. Control Environment
2. Risk Assessment
3. Control Activities
4. Information and Communication
5. Monitoring
The Control Environment sets the tone of the organization by
influencing the control consciousness of its people. It is the foundation for all
other components of internal control, providing discipline and structure
(AICPA, 1998). The auditor should obtain sufficient knowledge about
management’s and governing body’s attitudes, awareness, and actions
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concerning the control environment. In addition, the auditor should consider
both the substance of controls and their collective effect.
A risk assessment for state and local government organizations should
include an analysis of material risk factors that are relevant to the preparation
of financial statements. Such risk factors include noncompliance with certain
laws and regulations that may have a direct and material effect on amounts
reported in the financial statements. An analysis of risk factors is the most
important element of the auditor’s understanding of the organization’s internal
control environment. Table 3-6 provides the more common risk factors that
are considered during an audit of financial statements for state and local
government organizations.
Control activities are the policies and procedures that help ensure
management directives are implemented. They ensure necessary actions are
taken during operations to address risk factors and achieve objectives. An
example of a control is the reconciling of cash on the general ledger to the
banker’s balance. The auditor should obtain an understanding of those
control activities relevant to planning the audit.
Information and communication are critical elements for an accounting
system to meet financial reporting objectives. Those objectives include
properly accounting for operations and special events and transactions, as
well as effectively communicating financial data. The system-generated
financial information must provide quality financial data that are reliable,
timely, and useful.
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An important management responsibility is to establish, maintain, and
monitor internal controls. Management monitors controls to consider whether
they are operating as intended and if they are being modified as appropriate
for changes in conditions. The auditor should obtain sufficient knowledge of
the major types of activities the entity uses to monitor internal control over
financial reporting, including how those activities are used to initiate corrective
actions.
After obtaining this understanding, the auditor must assess and
document the control risk for the assertions embodied in the account balance,
transaction classes, and disclosure components of the financial statements.
The independent auditor uses the knowledge he or she has gained about
internal control and the assessed level of control risk in determining the
nature, timing, and extent of substantive tests on financial statement amounts.
Table 3-6 summarizes common risk factors associated with state and
local financial audits within two categories. The risk of errors, fraud, or illegal
acts category relates more to internal accounting control activities and
noncompliance with laws and regulations. A government organization’s
involvement in a risky, complex entrepreneurial activity would not appropriately
fit into this category. However, it could fit into the risk of external and internal
events category. This category includes risk factors such as changes in
operating environment, new lines, products, or activities, etc. Unfortunately,
ASLGU does not provide any examples of these kinds of risk factors. In
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addition, there is no discussion on current environmental trends such as the
new entrepreneurial paradigm described by Osborn and Gaebler (1993).
External and internal risk factors in the Guide need to be expanded to
include a discussion of entrepreneurial risks. The Guide should illustrate a
model of how an auditor should shift her or his focus among risk factors while
assessing the forces that affect organizations, such as internal accounting
controls, governance mechanisms, internal and external forces, and
entrepreneurial activities. Chapter 5 suggests a model that addresses the
need to expand ASLGU in this area.
3.4 SINGLE AUDIT ACT AND OMB CIRCULAR A-133
3.4.1 Background
Before 1984, several different teams of auditors audited government
organizations. At any given time, separate teams of auditors were auditing
different programs and departments. Oftentimes, the same staff was
responsible to handle and coordinate the audits. Administrators were constantly
frustrated because these audit teams would examine many of the same
accounting and administrative systems. Since each of these auditors was
auditing a separate piece of the government, in many instances, no one was
auditing the entire entity. Furthermore, the organization would have to pay for
these numerous and relatively ineffective audits. As a result of this overlap of
government audits, the Single Audit Act of 1984 was established.
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Table 3-6
Risk Factors for Government Financial Audits
Risk of Errors, Fraud, or Illegal Acts
• The existence of laws, rules, and •
regulations that may have a direct and
material effect on amounts reported in
the financial statements
• Unusual or unexpected transactions, •
events, amounts, ratios, or trends
noted as a result of analytical
procedures
• The existence of material accounting •
estimates
• The existence of many contentious or •
difficult accounting issues
• The existence of significant difficult-to- •
audit transactions
• The appearance of an unduly •
aggressive attitude on the part of
management toward financial reporting
• The management’s poor reputation in •
the governmental management
community
• The circumstance that the •
governmental unit is a new client and
sufficient prior audit information is not
available from the predecessor auditor
(see SAS No. 84, Communications
Between Predecessor and Successor
Auditors [AICPA, Professional
Standards, vol. 1, AU sec. 315])
• The potential for management •
misrepresentation
• The susceptibility of assets to
unauthorized use or disposition
• The effectiveness of the overall
financial controls, including the ability
to operate within approved budgets
and issue timely and accurate financial
reports
The appropriate segregation
of duties and responsibilities
The dependence of the
governmental unit on one or
more individuals to operate
key programs or manage the
budget or financial reporting
function
The effectiveness of the
internal audit function
Turnover of key personnel
Qualifications of key
personnel
Federal or state requirements
for expanded audit scope
Qualifications in auditors’
reports for prior years
The reduction or elimination
of federal or state grant funds
to finance key local programs
The ability of key subsidiary
accounting systems to
produce data necessary to
support financial statements
Decentralized or centralized
records
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Table 3-6
Risk Factors for Government Financial Audits
(Continued)
Risk of External and Internal Events
• Changes in operating environment
• New personnel
• New or revamped information systems
• Rapid growth
(AICPA, 1998, pp. 24, 25, 37)
The Act established uniform audit requirements for state and local
governments receiving federal financial assistance. The purpose of the Act was
to:
1. Improve the financial management of state and local governments with
respect to federal financial assistance programs;
2. Establish uniform requirements for audits of federal financial
assistance provided to state and local governments;
3. Promote the efficient and effective use of audit resources; and
4. Ensure that federal departments and agencies, to the maximum extent
practicable, rely upon and use audit work done pursuant to Chapter
75 of Title 31, United States Code (as added by this Act) (104th
Congress, 1996).
One of the important provisions included in the Act was designating the
Director of the Office of Management and Budget (OMB) as the person and
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• New technology
• New lines, products, or
activities
• Restructurings
• Accounting pronouncements
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office responsible for prescribing policies, procedures, and guidelines to
implement the law. In implementing the Act, the Director is to consult with the
Comptroller General of the United States.
The Comptroller General is appointed by the President and confirmed by
the Senate for a 15-year term. This is the longest non-judicial federal
appointment. The Comptroller General heads the General Accounting Office
(GAO) of the United States. The GAO is Congress' counterpart to the OMB.
The GAO's main responsibility is auditing federal agencies, including evaluations
of programs and policies.
To implement the Act, OMB issued Circular A-128. This Circular
originally described federal policy and prescribed procedures and guidelines to
follow. The Circular reiterated the Act's policy that every organization receiving
federal financial assistance greater than $25,000 is subject to an audit. A
governmental organization receiving $100,000 or more is subject to the Single
Audit Act. It also defined major federal financial assistance programs as the
greater of $300,000 or 3 percent of actual federal expenditures. The Circular
has many other technical procedures and guidelines.
An important technical requirement was that auditors had to follow
generally accepted government auditing standards (GAGAS). Generally
accepted government auditing standards are established by the General
Accounting Office of the Comptroller General of the United States. In addition,
the Circular required that governments who receive federal financial assistance
must have internal controls in accordance with GAO standards.
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Since OMB Circular A-128 was issued, there has been a lot of confusion
as to whether it applied to sub-recipients of state and local governments. Many
of these sub-recipients were nonprofit organizations and universities. As a
result, the OMB issued OMB Circular A-133. OMB A-133 is very similar to A-
128, except for some major changes in identifying major federal financial
assistance programs. It also gave the auditor the ability to establish materiality
guidelines, whereas A-128 did not provide any such guidelines.
3.4.2 New Single Audit Act and OMB Circular A-133 Requirements
Recently, the Single Audit Act (1996) was amended. As a result, the
Office of Management and Budget amended Circular A-133 (1997), to include
Audits of States, Local Governments, and Non-Profit Organizations. OMB
Circular A-128 was superceded by this change. The new amended Single
Audit Act is requiring auditors to use a risk-based approach when determining
major federal financial assistance programs rather than a formula-based
approach that was used under OMB Circular A-128.
The Single Audit Act Amendments of 1996 were enacted to streamline
and improve the effectiveness of audits of federal awards and to reduce the
audit burden on states, local governments, and nonprofit organizations. Those
goals were achieved, in part, by increasing the dollar threshold for requiring a
single audit to $300,000 in federal awards expended from $25,000 in federal
awards received and introducing a risk-based approach for determining which
federal programs are to be considered major programs.
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In performing audits in accordance with the standards applicable to
financial audits in Government Auditing Standards (GAGAS), the auditor
assumes certain responsibilities beyond those of audits performed in
accordance with GAAS as discussed in section 3-2. The reporting
responsibilities in GAGAS require additional reporting on compliance and on
internal control over financial reporting. Table 3-7 presents the relationship
among the compliance testing requirements of GAAS, GAGAS, the Single
Audit Act, and Circular A-133.
Table 3-8 presents the relationship among the requirements to consider
internal control under GAAS, GAGAS, the Single Audit Act, and Circular A-
133.
A matrix depicting the recommended auditor’s reports in a single audit
required by GAAS, GAGAS, and Circular A-133 appears in Table 3-9.
The audit scope depends on whether the federal awards expended are
identified as relating to major programs. Circular A-133 places responsibility
for identifying major programs on the auditor, and it provides criteria for the
auditor to use in applying a risk-based approach. The auditor’s determination
of programs to be audited is based on an overall evaluation of the risk of
noncompliance occurring which could be material to individual federal
programs. In evaluating risk, the auditor considers, among other things, the
current and prior audit experience with the organization being audited,
oversight by federal agencies and pass-through entities, and the inherent risk
of federal programs.
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Table 3-7
Compliance Testing
Generally
accepted
auditing
standards
Fieldwork
Responsibilities
Design the audit to provide
reasonable assurance that
the financial statements are
free of material
misstatements resulting
from violations of laws and
regulations that have a
direct and material effect on
the determination of
financial statement amounts
in accordance with SAS No.
54, Illegal Acts by Clients.
as described in SAS No. 74,
Compliance Auditing
Considerations in Audits of
Governmental Entities and
Recipients of Governmental
Financial Assistance, and to
provide reasonable
assurance about whether
the financial statements are
free of material
misstatements (whether
caused by error or fraud),
as described in SAS No. 82,
Consideration of Fraud in a
Financial Statement Audit.
and SAS No. 47, Audit Risk
and Materiality in
Conducting an Audit.
Reporting
Responsibilities
Requires the auditor to
adequately inform the audit
committee or others with
equivalent authority and
responsibility about any illegal
acts that the auditor becomes
aware of during the audit unless
they are clearly inconsequential.
Whenever the auditor has
determined that there is evidence
that fraud may exist, that matter
should be brought to the
attention of an appropriate level
of management. Fraud involving
senior management and fraud
that causes a material
misstatement of the financial
statements should be reported
directly to the audit committee.
When the auditor identifies fraud
risk factors that have continuing
control implications, the auditor
should communicate those
factors that are considered
reportable conditions to senior
management and the audit
committee. See SAS No. 82,
paragraphs 38 through 40, for an
additional discussion of the
reporting requirements of SAS
No. 82.
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Table 3-7
Compliance Testing
(continued)
Government Same responsibilities as
Auditing required by GAAS, but
Standards Government Auditing
Standards specifically
states that auditors should
design the audit to provide
reasonable assurance of
detecting material
misstatements resulting
from noncompliance with
provisions of contracts or
grant agreements that have
a direct and material effect
on the determination of
financial statement
amounts.
Requires a written report
describing the scope of the
auditor's testing of compliance
with laws and regulations and
presenting the results of those
tests (additional details on the
reporting responsibilities are
included in paragraphs 10.15,
10.16, and 10.21 through 10.25).
Single Audit
Act and
Circular
A-133
Determine whether the
entity complied with laws,
regulations, and the
provisions of contracts or
grant agreements pertaining
to federal awards that have
a direct and material effect
on each major program.
Requires the auditor to express
an opinion on whether the entity
complied with laws, regulations,
and with the provisions of
contracts or grant agreements
which could have a direct and
material effect on each major
program and, where applicable,
refer to a separate schedule of
findings and questioned costs.
(AICPA, 1998, SOP 98-3, pp. 7-8)
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Table 3-8
Internal Control Responsibilities
Generally
accepted
auditing
standards
Government
Auditing
Standards
Fieldwork
Responsibilities
Obtain an understanding of
internal control over financial
reporting sufficient to plan
the audit by performing
procedures to understand
both the design of controls
relevant to an audit of
financial statements and
whether they have been
placed in operation, and
assess control risk, in accor
dance with SAS No. 55,
Consideration of Internal
Control in a Financial
Statement Audit, as
amended by SAS No. 78,
Consideration of Internal
Control in a Financial
Statement Audit: An
Amendment to SAS No.55.
Reporting
Responsibilities
Requires the auditor to
communicate, either orally or
in writing, any reportable
conditions as described in
SAS No. 60, Communication
of Internal Control Related
Matters Noted in an Audit.
Same responsibilities as
GAAS. Government Auditing
Standards provides
additional guidance on the
control environment,
safeguarding controls,
controls over compliance
with laws and regulations,
and control risk
assessments.
Requires a written report
describing the scope of the
auditor’s testing of internal
control and presenting the
results of those tests. Also
requires separate identification
and written communication of
all reportable conditions,
including those reportable
conditions that are individually
or cumulatively material
weaknesses.
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Table 3-8
Internal Control Responsibilities
(continued)
Single
Audit
Act and
Circular
A-133
(AICPA,
Fieldwork
Responsibilities
With regard to internal control
over compliance, the auditor is
required to do the following (in
addition to the requirements of
Government Auditing
Standards): (1) perform
procedures to obtain an
understanding of internal control
over federal programs that is
sufficient to plan the audit to
support a low assessed level of
control risk for major programs,
(2) plan the testing of internal
control over major programs to
support a low assessed level of
control risk for the assertions
relevant to the compliance
requirements for each major
program,* and (3) perform tests
of internal control (unless the
internal control is likely to be
ineffective in preventing or
detecting noncompliance).
Reporting
Responsibilities
Requires a written report on
internal control over major
programs describing the scope
of testing internal control and
the results of the tests, and,
where applicable, referring to
a separate schedule of
findings and questioned costs.
1998, SOP 98-3, pp. 8-9)
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Table 3-9
Reporting for Single Audits
Required by -
Report GAAS
Government
Auditing
Standards
Circular
A-133
Opinion (or disclaimer of opinion) on
financial statements and
supplementary schedule of
expenditures of federal awards
X X X
Report on compliance and on
internal control over financial
reporting based on an audit of
financial statements
X X
Report on compliance and internal
control over compliance applicable
to each major program (this report
must include an opinion [or
disclaimer of opinion] on
compliance)
X
Schedule of findings and questioned
costs
X
(AICPA, 1998, SOP 98-3, p. 10)
The amended Single Audit Act and new OMB Circular A-133
requirements are focused on auditing of federal programs. Most federal
programs do not get involved with risky, complex entrepreneurial activities.
However, occasionally, their funds may be inappropriately used for other
purposes. The current audit model does properly address risk factors
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associated with this possible dynamic. The amended Single Audit Act (104th
Congress, 1996) addresses it by requiring the auditor to use a risk-based
approach when auditing major federal programs.
Any proposed state and local financial audit model still must include an
approach that addresses laws and regulations. The general area of laws and
regulations would include federal programs in accordance with the Single
Audit Act and OMB Circular A-133, and other areas as well, including local
laws and ordinances, state codes, etc. The proposed audit model in Chapter
5 incorporates the area of laws and regulations as one of the forces involved
in state and local government financial audits.
This Chapter has presented standards that comprise the existing state
and local financial audit model. The Chapter also has discussed the need to
improve or revise the standards. The next section summarizes the proposed
new reporting model (financial statements) for state and local government
organizations.
3.5 GASB REPORTING MODEL
The Governmental Accounting Standards Board (GASB) has recently
issued an exposure draft (ED) on Basic Financial Statements and
Management Discussion and Analysis for State and Local Governments
(GASB, 1997) and the final GASB Statement No. 34 (GASB, 1999). This
statement drastically changes the reporting model for state and local
government organizations. The proposed reporting model will include a
management’s discussion and analysis section, a set of basic financial
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statements presented in two ways (entity-wide perspective and fund
perspective), and notes to the financial statements. The GASB set forth the
fundamental objectives of general purpose external financial reporting for state
and local governments in GASB Concepts Statement No. 1, Objectives of
Financial Reporting (GASB Codification, 1999). The objectives of GASB
Concepts Statement No. 1 are broad, encompassing both operational and
fiscal accountability. The GASB has come to believe that the type of
information needed for operational accountability and the type of information
needed to demonstrate fiscal accountability are not necessarily the same
(Gauthier, 1997).
GASB believes operational accountability can be assessed only from
the perspective of the overall financial reporting entity and must necessarily
focus on flows of economic resources reported using the accrual basis of
accounting and depreciation. Conversely, GASB also believes that fund
accounting is essential for assessing fiscal accountability and that
governmental funds should continue to focus on flows of current financial
resources and should continue to employ the modified accrual basis of
accounting. Consequently, the exposure draft proposes a “dual-perspective”
reporting model. This means that entity-wide financial statements will be
based on the accrual basis of accounting, and fund financial statements will be
based on the modified accrual basis of accounting. Both sets of financial
statements, or “perspectives,” would be of equal importance and essential for
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fair presentation in conformity with generally accepted accounting principles
(Gauthier 1997).
Figure 3-2 illustrates the minimum requirements for general purpose
external financial reporting for state and local municipalities.
3.5.1 Entity-wide Perspective (EWP)
Effective fiscal year ending June 30, 2002, state and local government
organizations will report all capital assets, including infrastructure assets, at
the entity-wide perspective and will report depreciation expense as a charge to
operations for each period. Under current standards, reporting most
infrastructure assets is optional. Also, local municipalities currently do not
report depreciation expense for general capital (fixed) assets; rather, they
report expenditures of financial resources when they purchase or construct the
general capital assets. That reporting will continue at the fund perspective.
The new standards for the entity-wide perspective will require government
organizations to recognize them and assign their cost to the periods benefited
(GASB, 1997).
The GASB proposes in the ED, for the EWP, that municipalities prepare
two basic financial statements: (1) a statement of net assets and (2) a
statement of activities. The basis of accounting would be the accrual basis.
The EWP would report a separate column or columns for discretely presented
component units (related organizations), but would not report fiduciary funds.
Separate columns would be presented for governmental activities and
business-type activities with a mandatory total column for the primary
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government. The format of the statement of activities would be designed to
highlight the net cost of programs.
3.5.2 Fund Perspective
The GASB proposes that municipalities prepare three basic financial
statements for governmental funds at the fund perspective (FP): a balance
sheet; a statement of revenues, expenditures, and changes in fund balances;
and a budgetary comparison statement (GASB, 1997). Governmental funds
would continue to use modified accrual accounting, and the difference
between fund assets and liabilities would be reserved and unreserved fund
balances. The general fixed assets account group and the general long-term
debt account group would be eliminated.
The ED also proposes that municipalities prepare three basic financial
statements for proprietary (business-type) funds at the FP: a balance sheet; a
statement of revenues, expenses, and changes in fund equity; and a
statement of cash flows. The balance sheet would need to be classified
between current and non-current assets and liabilities.
Municipalities would be required to prepare only two basic financial
statements for fiduciary funds at the FP: a statement of net assets and a
statement of changes in net assets. As noted previously, fiduciary funds
would only be reported at the FP and not at the EWP.
The ED, also, provided criteria for disclosing major funds within
government organizations. In addition, there are no requirements for reporting
discretely presented component units at the FP level.
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Figure 3-2
Illustration of the Minimum Requirements for
General Purpose External Financial Reporting
Illustration of the Minimum Requirements for General Purpose
External Financial Reporting
M a n a g e m e n t's d is c u s s io n
a n d a n a ly s is
E n tity -w id e p e r s p e c tiv e
fin a n c ia l s ta te m e n ts
F u n d p e r s p e c tiv e
fin a n c ia l s ta te m e n ts
N o te s to th e fin a n c ia l s ta te m e n ts
O th e r r e q u ir e d s u p p le m e n ta r y
in fo r m a tio n
(GASB Exposure Draft, Proposed Statement of the Governmental Accounting
Standards Board, Basic Financial Statements - and Management’s
Discussion and Analysis - for State and Local Governments, Jan. 31, 1997,
p. 6.)
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3.5.3 Management Discussion and Analysis
The ED proposes that management’s discussion and analysis (MD&A)
is the first component of the financial section of the CAFR. MD&A would
introduce the financial statements by giving readers a brief, objective, and
easily readable analysis of the government organization’s financial
performance for the year and its financial position atyear-end (GASB, 1997).
The ED further proposes that the MD&A be treated as required supplementary
information. Accordingly, auditors would be responsible for performing certain
limited procedures regarding the data included in the MD&A but would not be
required to audit it (Gauthier, 1997).
The GASB Chairman, Tom L. Allen, said it is likely that the effective
date for the implementation of the financial reporting model will be extended.
Allen said (Journal of Accountancy, 1997) that even if the GASB went forward
with its proposal with no modifications, the proposed two-year implementation
period and the June 15, 2000 effective date may not be met.
The proposed reporting model has several changes that will be new to
state and local government organizations. The MD&A sections of the
proposed model are similar to MD&A information required on publicly-held
private corporations. The information will be treated like required
supplemental information. Therefore, the auditor will be required at least to
review and make certain inquiries regarding the information contents. The
way auditors approach this section depends on the information that is
presented in the MD&A. The section may discuss the organization’s
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involvement in a complex, risky entrepreneurial transaction. For a transaction
like this, the auditor may want to use elements of the proposed audit model in
Chapter 5.
The entity-wide perspective presents financial statements that are
under the accrual basis of accounting and are similar to business
organizations. For business-type financial statements, it makes sense to have
an audit approach that addresses entrepreneurial activities. The model in
Chapter 5 discusses how it can be adjusted for the unique issues presented
by the entity-wide perspective financial statements. Since the proposed model
deals with risk factors, it makes sense to use it for major funds for the fund
perspective financial statements, also.
3.6 CONCLUSION AND TRANSITION TO CHAPTER 4
This Chapter reviews all the important auditing standards that comprise
the existing auditing model for state and local government financial audits.
The Chapter shows that the existing auditing model is comprised primarily of
standards from the GAO, AICPA, OMB, and GASB. The existing model does
an adequate job of auditing internal controls and laws and regulations. In fact,
it identifies several risk factors associated in these areas. Unfortunately, it
does not clearly identify or provide examples of risky transactions that
government organizations are getting more involved with lately. The Chapter
identifies several areas where the existing model can be improved.
One area for improvement is simply better definition and identification of
entrepreneurial transactions. Another area is to provide examples of complex,
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risky entrepreneurial transactions and activities. The model should also
address governance mechanisms like laws and regulations. State and local
municipalities’ resources are often required to be used in accordance with
established policies, laws, and regulations. The proposed model should also
address the needs of the new reporting model for state and local government
organizations.
The next Chapter discusses theoretical models that were helpful in
creating the proposed auditing model in Chapters. The theoretical models
that are analyzed and modified to fit this study’s needs are agency theory,
institutional theory, and risk theory. Unlike the existing auditing model, the
auditing model presented in Chapter 5 is grounded in a theoretical framework.
The existing auditing modei was developed from generally accepted practice.
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CHAPTER 4
THEO RETICAL MODELS AN D LITERATURE REVIEW
4.1 INTRODUCTION
Public administration is a constantly changing field because it has the
difficult task of implementing public policy. Evaluating the implementation of
public policies is a unique profession that demands a special theoretical
foundation. The job of implementing public policy is something Woodrow
Wilson (1887) wrote about in his article, ‘The Study of Administration.” The
article described the state of public administration around the turn of the
century. Wilson felt that public administration was easier in the 18th century
than the 19th century because society was not as complex.
Today, society is even more complex because values appear to have
the capacity to change rapidly. Kirlin (1984) studied values, particularly, their
effects in government institutions. Kirlin’s definition of government is more
comprehensive than Wilson’s definition; he believes governments are the
institutions of society that have singular obligations to facilitate societal choice
making and action. This view is not necessarily synonymous with service
delivery. However, this paper takes the position that public administration
includes the service delivery process of government institutions.
Within public administration, a need exists to develop theories and
methodologies to evaluate the implementation of public policies or the service
delivery process. The auditing profession is a discipline that evaluates the
implementation of policies using generally accepted auditing standards
(AICPA, 1999). The profession’s generally accepted auditing standards
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should more consciously incorporate societal values. This chapter develops
the theoretical backdrop for a framework that incorporates the complex nature
of entrepreneurial activities for state and local financial audits. Reflecting the
field of public administration, the proposed theoretical framework has drawn
from other disciplines.
4.1.1 Theory Construction for Public Administration
Public administration theories draw from other disciplines which are
grounded in basic scientific methods. Empirical analyses and studies are
often performed in controlled, static environments. Theory development is
done from a deterministic perspective. Kirlin (1984) related this theory
perspective to "logical positivism," which is only one approach in scientific
methods. Unfortunately, public administration simply does not work this way.
Although this kind of theory construction is still relevant, many researchers
advocate future uses of different theoretical models.
The dynamics of public administration require theoretical models that
can address the needs of public administrators. Organizational theories
originally developed in Germany and France that focused on centralization
were adopted in America. These theories have been difficult to develop
because of our complex government systems and an assumed static
environment. No one theoretical approach should be deemed the only way to
analyze and predict the performance of public agencies and political systems.
Obviously, theory development must fit the circumstances. Theoretical
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development should both develop and analyze the dynamics caused by
political choice making.
H. Miller (1994) analyzed the question of whether progressivism will
endure as the conceptual foundation for public administration. Miller feels that
traditional progressivism models, which include hierarchical control, scientific
management, and neutral competence, allow public administrators little room
to use discretion or to process political claims. Although Miller felt that
progressivism models still have legitimacy, he believed policy network models
will be more appropriate for the future. Miller (1994) also felt that a network
model premised on economic utility explains events better than traditional
progressivism models. In addition, Miller believes network models should
include social constructionist theories because collectively they have
normative advantages over both progressivism and economic exchange
models.
The advantages of having network models for analysis are they take
into account several facets of the subject matter. The exchange theory model
takes into account the theoretical perspectives of rational choices made from
interactions. The constructivist network model makes it clear that political
interaction is endemic to the craft of public administration. Administrators
frequently find themselves among members of the public, struggling to sort out
meanings and values, to construct institutional arrangements, and to channel
public resources in desired directions (H. Miller, 1994). The progressivism
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model still has its place in the analysis of public administrative theory,
especially in standard and routine activities.
Kirlin (1984) also suggests a broader framework for evaluating
government performance. He bases this framework on his definition of
government as the institution of society with singular obligations to facilitate
societal choice making and action. Kirlin emphasizes that the capacity for
choice making and action is not synonymous with service delivery. He
subscribes to moving from a logical positivist philosophy to a pragmatic
philosophy of science. Kirlin also believes government policies are
evolutionary. Therefore, choices are made within the constraints of previous
choices. Kirlin advocates theory construction that incorporates the choice-
making role of the political system as opposed to simply service provision.
This pragmatic view of theory construction is similar to the one advocated by
T. Miller's designed system of theory construction.
Golembiewski (1996) also advocates moving away from one
predominant theoretical approach. He believes the theory of Rational
Volunteer Action should not be the basic body of thought. Golembiewski
believes that not having a complement of sound, proven theoretical
approaches contributes to the polarization of ideas which must be
counterbalanced. He explained the appropriateness of using empirical theory,
goal-based empirical theories, and action theories. Similar to Kirlin (1984), he
believed the features of action theories speak to public administration’s
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contemporary conditions; and these theories deserved increasing attention
from researchers.
Table 4-1 places bodies of theories already discussed into broad
theoretical categories. The table further surrounds these categories with the
idea of using a network of models for the development of theory.
Table 4-1
Broad Theoretical Categories
For Governmental Financial Auditing
• Logical Positivism or Progressivism Theories
- Scientific Methods/Management
- Hierarchical Control
- Centralization
- Neutral Competence
• Social Constructionist Theories
- Normative Advantages
- Societal Values
- Institutional Arrangements
• Economic Theories
- Exchange Theories
- Rational Choice Making Theories
- Action Theories
Network of Models (Miller, 1994)
Pragmatic Model Development (Kirlin, 1984)
(Original table)
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4.1.2 Program Evaluation Theory
Theory construction for government auditing should consider multiple
models. Auditing is a form of program evaluation. Methodologies from
program evaluation can be used in theory construction for auditing
government organizations.
The field of public administration should develop improved
methodological approaches in evaluating its programs and operations
because there are many forces that affect the operations of government
organizations. These forces are summarized in the conclusion section of this
chapter and further developed in Chapter Five. The concept of accountability
for the implementation of public policies also demands improved evaluation
(auditing) models. There are several methods currently being utilized that can
be further considered in theory construction for government auditing.
One method that should be considered is Total Quality Management
(TQM). This method as defined by Deming (1986) is a quality evaluation of
the entire organization with a customer focus. TQM has been successfully
applied to manufacturing organizations, and many of its principles are
applicable to the public sector. Swiss (1992) argued that orthodox TQM
stresses products versus services and simply will not work well in government
organizations. Rago (1994) felt that TQM could apply to government
organizations because they are still quite process-oriented.
TQM is being applied to several municipal and state governments
throughout the United States with mixed success. One of the reasons given
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for poorer performances is the lack of support for the TQM program. A TQM
program simply requires an organizational cultural change with respect to how
to conduct the operations of the organization. Even though the program has
had mixed success, competition within and between government jurisdictions
simply requires organizations to rethink how they conduct their affairs. TQM is
a good methodology for challenging an organization’s operations and properly
identifying the customer(s) for its programs.
Another method helpful in determining whether public policy has been
properly implemented for both choice making and service delivery is
performance budgeting and evaluation. The system establishes performance
measurement goals for the organization to meet and evaluates programs and
operations based on these measures. Wholey and Hatry (1992) argued that
performance monitoring for public programs is feasible and useful.
Performance monitoring and regular reporting can inform elected officials and
citizens and keep them involved in governance. A major detriment in the
system, though, is the time and cost involved in establishing the systems
necessary to capture and maintain the data. In addition, there are ways to
manipulate the data in favor of a program. Still, performance budgeting and
evaluation programs are being implemented.
One reason why performance budgeting and evaluation programs are
being implemented is because governmental resources are limited, and public
organizations must find methods to help them manage their limited resources.
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Measuring and managing policy objectives are other reasons why
performance budgeting and evaluation programs are being implemented. By
simply establishing performance criteria for a given program, the policy maker
can rationally monitor a program based upon his or her original expectations.
It should be noted that measuring the implementation of public policies is
similar to government auditing objectives. Other methodologies and theories
that align with the theoretical categories of choice making/exchange are
agency and risk.
Agency and risk theories can be used to develop frameworks that could
support auditing methodologies and procedures; for example, the auditing of
an entrepreneurial activity such as a payroll system based upon performance.
The level of an executive's compensation could be an increasing function of
his or her performance. Incentive programs and appraisal systems are
becoming more frequent in state and local government organizations and a
growing trend for their use in public administration in the future can be
anticipated.
Social Constructionist models would include institutional and
entrepreneurial theories. The constructivist network models of institutional and
entrepreneurial theories incorporate political interaction into the craft of public
administration. Institutional theory frames societal values and explains how
they shift through charisma of a visionary leader. The leader understands and
exploits the political dynamics to create change. Recently, according to
Osborne and Gaebler (1992), many of these changes include entrepreneurial
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activities. Entrepreneurial theory captures recent political and societal views
on how government organizations should operate. Entrepreneurial theory and
institutional theory will be helpful to a financial auditing model in framing the
understanding of government organizational environment.
Table 4-2 fits program evaluation theories into the broad theoretical
categories previously introduced.
Table 4-2
Broad and Detailed Theoretical Categories
For Governmental Financial Auditing
• Social Constructionist Theories
- Performance Budgeting
- Institutional Theory
- Entrepreneurial Theory
• Organizational Behavior
- Total Quality Management
• Economic Theories
- Agency Theories
- Risk Theories
(Original table)
4.1.3 Recent Public Administration Fad
Reinventing government is the latest government fad. The premise of
reinventing government is to make government organizations more
entrepreneurial. This section correlates this latest paradigm to the most recent
government auditing studies
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Osborne and Gaebler (1992) wrote about reinventing government,
which is basically an entrepreneurial approach to government administration.
The premise of their books and articles is that government organizations
should operate more like businesses. Osborne and Gaebler believe
government organizations still have room to save money without eliminating
services. One method they suggested that is being used is to have
governmental departments compete with private sector organizations in the
delivery of services. An example they used was the City of Phoenix garbage
collection services. Apparently, the Waste Management Department lost and
then won back the contract to provide services over a private contractor. This
competition forced the department to rethink their service delivery and become
competitive and efficient. During the process, the customers were better
served.
These authors’ concepts are very similar to many of the theories and
approaches that have been analyzed and written about. For example,
customer focus is a concept that has been the driving force behind TQM
programs. In addition, rational choice and competition are models discussed
by economic theory. The point of this discussion though is, is this a fleeting
fad? Reinventing government is a fad that fits into the future of the public
administration environment. Many of its tenets are consistent with current
theory, and its acceptance is something public administrators will need to deal
with in the future.
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Wilson and Durant (1994) discussed Al Gore's campaign to reinvent the
federal government with the National Performance Review (NPR). According
to Wilson, the act changed several government objectives such as
government efficiency to public entrepreneurship and expansion of power to
restoration of reputation. The act also summarized the lack of confidence in
governmental organizations. Two of NPR's important proposals are
empowering employees and putting the customer first. Wilson feels that this
program will fail. Organizations cannot make the wholesale changes required
by the NPR without significantly changing the organizational culture and
drastically reducing the workforce. These kinds of implementation problems
were identified with TQM programs in municipal governments. However, the
Government Performance and Results Act and TQM programs are still being
implemented and will be part of the landscape of public administration in the
future.
Another significant area of public administration is the identity crisis it
has had. The time is ripe for public administration to finally put this crisis
behind it because the lines of public and business administration are
increasingly being blurred. Waldo (1992) sees an emergence of a new pattern
of public and private categories. He noted that previous categories were
based upon history, culture, laws, and customs. However, he believes there is
a movement away from the sharp distinction between public and private, and
towards a blurring and mingling of the two. Public administration should seize
the opportunity to redefine its role in identifying what are public activities. This
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redefinition can help public organizations meet the demands of their
constituents. This approach is consistent with other suggested changes, such
as a new construction of theory, downsizing of government activities because
of reduced resources, and reinventing government.
Theory construction for government auditing has been limited. Most
work has been descriptive; namely, providing details on audit functions,
procedures, and practices. Tierney’s (1979) contributions are guides for
accounting and auditing practices relating to government organizations. In the
literature on government auditing, conceptual issues are not widely debated;
this has hampered the development of a conceptual framework to anchor
relationships and practices for government auditing methodologies.
Hardman (1991) suggests a conceptual framework for government
auditing by using agency theory. His work explores “monitoring models” of
government auditing. He identifies three models -- sole monitoring, dual
monitoring, and commercial monitoring models. These models are different in
terms of whether you use government auditing organization(s) or use a
combination of government and private audit organizations. He concluded
that it depends on the circumstances. Although his framework would be useful
for other analyses, this study is more concerned with a theoretical framework
for local California financial, government auditing.
The next four sections of this chapter discuss theories that will be used
in this study’s proposed auditing model. These theories have been placed in
broad and detailed theoretical frameworks provided in Table 4-2. Each theory
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is related to a pragmatic application which is used in Chapter Five’s proposed
auditing model. The four theories the study further reviews are public
entrepreneurship, risk, institutional, and agency theories.
4.2 PUBLIC ENTREPRENEURSHIP
The public entrepreneurial paradigm is relatively new within public
administration. Although public entrepreneurship has been manifest in
practice since the 1970s, researchers significantly started studying this
paradigm in the 1980s. However, it was not until the early 1990s that the
public entrepreneurship view started gaining general acceptance. Osborne
and Gaebler (1992) wrote Reinventing Government, which stimulated the
momentum for public entrepreneurship. Governments are being asked to
provide services with reduced resources. To help stretch government
resources, administrators are using more entrepreneurial activities.
Entrepreneurial governments typically have moved from centralization to
decentralization, from monopoly to competition, from bureaucratic
mechanisms to market mechanisms, from politically-driven citizens to
customer-driven systems, from rule-driven organizations to mission-driven
organizations (Osborne and Gaebler, 1992).
Other researchers’ descriptions and definitions of public
entrepreneurship have varied. Fisher (1981) emphasized the term,
“entrepreneur,” which comes from the private business world. The term is
largely reserved for those rugged individuals who have invested their time,
talents, and resources moving them from less productive into more productive
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investments, thus creating wealth. The entrepreneur must be prepared to risk
his/her reputation and to invest time and energy into the realization of ideas
that are only defendable based on future outcomes, not on current gains.
Finally, entrepreneurship is antithetical to bureaucracy and largely alien to
public governance. The entrepreneur must constantly scan the boundaries of
the system and find ways to poke holes in it.
Terry (1993) questioned whether the private enterprise concept of an
entrepreneur is an appropriate model for public administration. He believes
this model contains insurmountable problems that render the concept
unsuitable for prescribing or describing the role of public administrators in
governance.
Chapman’s (1996) definition for public entrepreneur might well be
adjusted to a modified version -- the risks that an entrepreneur may take can
lead only to small gains in the worst case, never to losses. He analyzed the
entreprenuership activity of Orange County’s risky investment practices that
lead to the County’s bankruptcy. He believes three conclusions can be drawn
from that situation. The first is there is an uncertain price to be paid for being
an entrepreneur. A second conclusion is entrepreneurship in the public sector
is different than the private sector. The third lesson is entrepreneurial
uncertainty in the public sector is causing additional constraints (government
codes, laws, and regulations) on entrepreneurial activity in order to protect the
public from poor decision making.
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Kirlin (1995) believes contemporary discussion in public administration
and reform efforts often undervalues the large roles governments must
successfully perform in providing institutional frameworks for human activity.
He uses Public Entrepreneurship as a term to describe value creation
dimensions of government. His definition for entrepreneurship is a
commitment to change, wealth creation, and value-adding processes. When
you add the modifier “public,” this now means to create value without which
“private” entrepreneurship would be rare and very difficult. Kirlin also believes
increasing the value of place (the location where you live) is the primary
function of governments.
North’s (1990) view about entrepreneurs is similar to Kirlin’s. He
believes that entrepreneurs should help change institutions (add value).
Institutions, along with economic realities, determine the opportunities in a
society. Organizations are created to take advantage of those opportunities,
and, as the organizations evolve, they alter institutions. Institutions
incrementally change through the perceptions of entrepreneurs in political and
economic organizations because they recognize the possibilities of doing
better by altering the existing institutional framework. North argues that only
when we understand modifications in the behavior of the actors can we make
sense out of the existence and structure of institutional change. North uses
rational choice theory to delve into two particular aspects of human behavior:
(1) motivation and (2) deciphering the environment.
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As described in Chapter 1, the above-mentioned researchers provided
the definitions and descriptions of entrepreneurial activities that were used to
arrive at this study’s own definition. The risky use of public resources in the
creation of value for the people is this study's definition of entrepreneurial
activity. The study further describes a public entrepreneur as an individual
who takes risks with public resources in creating value for the people.
Chapter 2 of this study provides examples of entrepreneurial activities
in several California municipalities. These complex, risky transactions should
be audited during the audit of the financial statements. One way to
incorporate entrepreneurial activities in the government organization’s financial
statement audit is to understand and compare the values of entrepreneurs
and democratic values. The following researchers provide a good description
of values this study can use in its theoretical model.
Bellone and Goerl (1992) labeled the 1980s as the “age of the
entrepreneur.” These authors discussed the behavior of public entrepreneurs.
This behavior must be consistent and compatible with democratic values. The
dichotomy in values between entrepreneurs and democracy is shown in Table
4-3.
The authors believe government organizations can be involved in
entrepreneurial activities. However, they also believe each entrepreneurial
activity should go through a meaningful public participation process. Public
administrators and others should demonstrate through this process that the
proposed activity is compatible with the values of democratic participation.
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The values described by Bellone and Goerl (1992) can be incorporated in a
government audit model and can be identified as separate risk elements for
the model. The next section describes risk theory in more detail. These
democratic values are incorporated in the risk model presented. The
democratic values and the risk model that incorporates those values are part
of the proposed state and local financial audit model presented in Chapter 5.
Table 4-3
Entrepreneur vs. Democratic Values
Entrepreneurs’ Values Democratic Values
Autonomy Accountability
Personal Vision Citizen Participation
Secrecy Open Policymaking
Risk-taking Stewardship
(Bellone and Goerl, 1992)
Jackson and Rodkey (1994) studied organizational climates conducive
to implementing an entrepreneurial activity. Their study determined that the
presence of entrepreneurial attitudes among a population may be an important
indicator of the pool of potential entrepreneurs. The results indicated that
people living in areas dominated by large employers, even if they do not work
for a large employer, are less likely to have attitudes supporting
entrepreneurship activity. Obviously, this finding could apply to other regions
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and situations. A second negative relationship for this kind of activity is the
level of unemployment in a region, and an individual’s belief in the ease of
starting and growing a new business. Also, people are more conservative
when they approach retirement (Jackson and Rodkey, 1994).
Several other articles discuss how public organizations implemented
entrepreneurial programs. Perlmutter and Cnaan (1995) argue that a policy of
fundraising and development is one solution to tax base decline, diminished
state and federal support, and intensified public demand for more and better
services. Their article is a case study on how the Department of Recreation of
Philadelphia implemented a development unit and annual fundraising
campaign. The authors also observed that changes like this program need
more than a charismatic leader; they need the program to be institutionalized
within the organization. This observation is similar to Kirlin’s (1995) value
creation concept of entrepreneurship. Tewes (1981) studied the
implementation of a reward system for the City of Long Beach. He observed
that departments under this approach competed for their revenue base.
Apparently, this competition created an atmosphere of service and innovation.
Wieman (1993) observed that inefficient public works management has
resulted in the deterioration and eventual neglect of infrastructures. The
author believes public entrepreneurship will likely result in more efficient
management of funds and manpower to help correct the problem. Cincinnati
has addressed the issue by using new revenue sources from the state gas tax
and an increase of 0.1 percent on local income taxes. As a result, the city
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doubled its reconstruction effort. A balanced maintenance program is less
costly and, interestingly enough, creates more jobs. The reason is that
building infrastructure is more capital intensive than labor intensive. Wieman
stressed promoting system efficiency.
4.3 RISK THEORY
This study develops a theoretical audit framework for risky
entrepreneurial activities in local California government agencies. The study
uses two theoretical areas to help study and address risk in financial
statement audits. Agency theorists have studied risk in different scenarios.
Agency theories and their application to financial statement audits are
analyzed in the last section of this chapter. The risk theories that are being
analyzed in this section come from the Statement on Auditing Standards
(SAS) No. 47 and 82 (AICPA, 1998). SAS 47, “Audit Risk and Materiality in
Conducting an Audit,” defines audit risk as the risk that the auditor may
unknowingly fail to appropriately modify his or her opinion on financial
statements that are materially misstated.
The standard provides guidance on the concept of materiality.
Materiality recognizes that some matters, either individually or in the
aggregate, are important for the fair presentation of financial statements in
conformity with generally accepted accounting principles (GAAP), while other
matters are not important. The auditor should consider audit risk and
materiality both in (a) planning the audit and designing auditing procedures
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and (b) evaluating whether the financial statements taken as a whole are
presented fairly, in all material respects, in conformity with GAAP.
The auditor needs to consider audit risk at the transaction level
because such consideration directly assists in determining the scope of
auditing procedures to use. SAS 47 says audit risk consists of (a) the risk
(consisting of inherent risk and control risk) that the transaction and related
assertions contain misstatements that could be material to the financial
statements and (b) the risk (detection risk) that the auditor will not detect such
misstatements. Table 4-4 summarizes the three elements of financial
statement risk.
Inherent risk and control risk differ from detection risk in that they exist
independently of the audit of financial statements, whereas detection risk
relates to the auditor’s procedures and can be changed at his or her
discretion. Detection risk should bear an inverse relationship to inherent and
control risk. The less the inherent and control risk the auditor believes exists,
the greater the detection risk that can be accepted. Conversely, the greater
the inherent and control risk the auditor believes exists, the less the detection
risk that can be accepted.
The financial statement risk areas described in Table 4-4 are used in
Chapter Five’s proposed audit model. In addition to the three risk elements
described, Chapter Five also introduces other risk elements associated with
government financial statement audits.
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Table 4-4
Financial Statement Risk Areas
• INHERENT RISK — is the susceptibility of an assertion to a material
misstatement, assuming that there are no related controls; for
example, the competitive industry the organization is participating in.
• CONTROL RISK - is the risk that a material misstatement could
occur in an assertion will not be prevented or detected on a timely
basis by the entity’s internal control.
• DETECTION RISK - is the risk that the auditor will not detect a
material misstatement that exists in an assertion.
(Original table)
SAS 82, “Consideration of Fraud in a Financial Statement Audit,”
defines and prescribes risk areas that may arise due to fraud. This study uses
the methodological approach the standard prescribes for fraud risk. That
approach involves six steps in evaluating fraud risk. The first step is simply
describing fraud and its characteristics or fraud potential for the organization
being audited. The second step requires the auditor to specifically assess the
risk of material misstatement due to fraud. The third step from the standard
provides auditor guidance on how to respond to assessment of fraud risk, for
example, additional testing or the assignment of more seasoned staff in the
risky area. The fourth step provides guidance on the evaluation of audit test
results as they relate to the risk of fraud. The fifth step is how the auditor
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should document his or her working papers for fraud. The sixth step is with
whom should the auditor communicate during this part of the audit.
SAS No. 82 became effective for audits of financial statements for
periods ending on or after December 15, 1997 (AICPA, 1998). The standard
was developed from the corporate world of auditing. Apparently, users of
corporate financial audits thought auditors included procedures to seek out
fraud. Under Statement of Auditing Standards (SAS) No. 53, ‘The Auditor’s
Responsibility to Detect and Report Errors and Irregularities," the standard
basically guided auditors to report material fraud only if they became aware of
it (Mancino, 1997). Therefore, there was a huge expectation gap between the
users and preparers of financial statement audits. SAS 82 began closing that
expectation gap by requiring the auditor to consider fraud while conducting a
financial statement audit, rather than report fraud only when the auditor
becomes aware of it. The former is a more proactive approach as opposed to
the latter which is more of a reactive approach to fraud. In fact, under SAS 53,
the Standard did not even use the word fraud in the auditing standards. SAS
53 used the word irregularities to mean something like fraud.
As previously mentioned, what is important about SAS 82 is its
methodological approach to describing, assessing, testing, evaluating, and
communicating fraud risk in organizations. This same approach can be used
in a theoretical audit framework for risky entrepreneurial activities in local
California government agencies.
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Table 4-5 summarizes the model in use for considering fraud in
financial statement audits.
Table 4-5
Consideration of Fraud in Financial Statement Audits
1. Describe Fraud and Characteristics
2. Assess Risk of Material Misstatements to the Financial Statements
3. Auditors Response to Assessment
4. Evaluation of Fraud Tests
5. Documentation Requirements
6. Communication Requirements
(AICPA, 1997, SAS 82)
The fraud risk areas and fraud risk model described above are used in
Chapter Five. Both help describe separate quadrants of the model. SAS 82
further provides a methodological approach that is used to consider
entrepreneurial activity risk.
4.4 INSTITUTIONAL THEORY
There are several methodologies used to evaluate the implementation
of public policies. Commonly used evaluation methods include total quality
management programs, performance budgeting and auditing systems, and
financial and program auditing. The Orange County bankruptcy raised
questions as to whether financial audit procedures should be expanded to
more accurately consider the government environment and the actors who
participate in it. The next two sections analyze the use of institutional and
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agency theories as a combined theoretical framework to enhance government
audit procedures as they relate to a financial audit.
4.4.1 Background
Walters (1996) suggests that California counties cannot effectively
govern under their current structure. The structure has no accountability. In
addition to the five elected members of the Board of Supervisors, there are
several other elected officials managing key functional areas; for example,
separately elected sheriffs, auditor-controllers, treasurers, etc. These elected
officials have no mandate to cooperate with the supervisors on any overall
policies of the county. This kind of institutional structure has evolved over
time. Walters believes the bankruptcy of Orange County was a direct result of
this organizational or institutional structure. If they understood this fragmented
institutional structure, financial auditors may have been able to foresee
Orange County's risky investment practices and appropriately disclosed them
to the public.
Financial auditing standards are developed to verify account balances
on an organization's financial statements. Financial statements are prepared
in accordance with reporting standards. The establishment of reporting
standards, according to Mezias and Scarselletta (1994), are imprecise and
inconsistent. Their study used garbage can and institutional theories to
explain how financial reporting problems are resolved. These auditors labeled
the decision process as an organized anarchy embedded in an institutional
context. Their research stands as a case study of how garbage can and
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institutional forces intersect to bring about change in the institutional
environment of accounting.
Since the establishment of reporting standards has been explained
using institutional and garbage can theories, financial auditing procedures can
also be explained using these theories as well. The reason financial auditing
standards are developed is to simplify audit reporting standards. However, for
governmental organizations, there have been a lot of mistrust and requests for
more accountability. Herzlinger (1996) recently wrote that nonprofits and
government organizations have lost the public's trust. She believes that one
solution would be for government organizations to provide disclosure,
analysis, dissemination of information, and sanctions if anything goes wrong.
In other words, provide a system based on more accountability and
performance.
Garbage can theory, which is a contingency theory, is certainly useful
when analyzing and explaining a dynamic, non-static environment dictated by
circumstances. However, this theory does not fit well when analyzing
accountability, performance, and outcomes for government organizations.
According to Perrow (1986), agency theory appears to apply the economics of
maximizing utilities, where net utilities are rewards (money) minus effort, to
explain contracts and organizations. Therefore, agency theory should be
more helpful than garbage can theory in developing a theoretical framework
that will deal with self-interests, performance, and motivation. This theory
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should be an effective theoretical base to develop audit procedures for the
performance in the cash and investment areas.
The use of agency theory with another complementary theory is not
new. Eisenhardt (1989) concluded that agency theory (a) offers unique insight
into information systems, outcome uncertainties, incentives, and risks and (b)
is an empirically valid perspective, particularly when coupled with a
complementary perspective. Using institutional theory to develop the audit
framework for understanding the organization...its environment, history,
values, limits, and culture...should be beneficial in developing government
auditing procedures. Agency theory should provide insight in developing
auditing procedures designed to measure accountability, especially for the
cash and investment area of the financial audit.
Sjoberg's (1995) Orange County audit report highlighted the reasons
the County was forced into bankruptcy. The Treasurer violated the basic
principles of prudent investing. He made investments that were unsafe, highly
risky, and extremely volatile. He leveraged the portfolio more than 2.7 times
and invested more than 40 percent in inverse floaters and other structured
securities. The Treasurer also violated his stewardship responsibilities altering
accounting records and misallocating earnings and losses. Both agency and
institutional theories would help in establishing a theoretical framework to be
used in developing sound government auditing procedures to help auditors
potentially disclose situations like Orange County.
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Osborne and Gaebler (1992) wrote about dealing with the crisis of
government today. The purpose of the book is to help map a direction for
government. These authors suggested government organizations should be
more entrepreneurial. Many government organizations are getting involved in
more risky transactions to help balance their budgets. Audit procedures
developed from a theoretical framework of institutional and agency theories
will help auditors keep pace with the entrepreneurial governance paradigm.
4.4.2 Institutional Theory
North (1990) believes that the major role of institutions in a society is to
reduce uncertainty by establishing a stable (but not necessarily efficient)
structure for human interaction. Perrow (1986) believes institutional theory's
major conceptual framework is that of structural-functionalism, indicating that
functions determine the structure of organizations and that structures can be
understood by analyzing their functions. Both views about structure are
similar.
The understanding of institutional structure and how it relates to an
organization can be helpful in the audit process. Institutional structure has
evolved over time. By simply understanding the historical aspects of
institutions, their structure, and how government organizations provide
services within this framework, auditors can better design their procedures to
evaluate the implementation of public policies.
Perrow's (1986) view about analyzing functions to understand
structures can be practically applied in auditing a government organization.
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For example, analyzing the function of the Treasurer's office can help in
understanding the societal value of accountability within government
institutions. The process of institutionalization and the development of
institutional structure can be further analyzed by identifying societal values.
The process of institutionalization leads to development of organic
growth, wherein the organization adapts to strivings of internal groups and the
values of the external society. By understanding key societal values and even
limits in the institutional environment, auditors will understand governmental
organizations better. Auditors can use this knowledge in properly designing,
writing, and performing audit procedures.
An overriding value incorporated in most of our public institutions is
democratic, representative government. Our nation was founded on the
principles of representative government. As written in Federalist No. 10
(Rossiter, 1961, p. 82), "It is assumed that the public voice pronounced by
representatives of the people will be more in consonant with public good than
if pronounced by the people themselves." Therefore, it is vital that public
administrators, including financial auditors, incorporate this overriding value
when evaluating public policies.
Another value incorporated in our public institutions is our check and
balance system which can be found at all levels of government. This value
explains why county government within the State of California is ineffectively
structured. The Federal government has the Executive, Legislative, and
Judiciary branches of government, which balance authority and power among
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themselves. California's counties have elected governing bodies and
appointed administrators. Unfortunately, unlike the Federal government where
this system was designed to slow down the process of policy making and
administration, county government and other local governments must be
active and anticipatory to deal with today's government environment (Osborne
and Gaebler, 1992). This value actually creates institutional limits that are
now being observed by columnists like Walters (1996).
Another important value incorporated in today's public institutions is
accountability. Since our government is empowered by the people, they have
the right to know what is happening during the governmental process. What is
accountability? It is information readily available to the public about the
government process. It can be in the form of open meetings of the city council
and the board of supervisors. It can be information available in public reports
on the rezoning plans of a county. It can be financial statements and audit
reports. Information from all these and many other sources helps citizens,
business owners, and interested parties monitor the process of government
and hold public servants accountable. Susan Rose-Ackerman, Rethinking the
Progressive Agenda ('19921. argues that policy makers and administrators
should be held even more accountable through an active court system.
Johnson and Lewin (1984) analyzed accountability models of public
sector performance. To improve the evaluation of government performance,
the article describes normative models of public service delivery. Internally-
oriented models are those used to enhance managers' abilities to improve
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performance. Externally-oriented models aim to provide citizens with more
precise performance indicators as a means of enhancing feedback to public
managers. To help measure performance, the authors identified goal and
system models. The goal model emphasizes establishing goal specifications.
The system model hypothesizes that improved performance results from
effective organizational design.
An important procedure in auditing is obtaining available data, which
may include reports, studies, minutes, etc. The value of accountability is
fundamental because the audit process relies on available data to direct and
focus the audit process. The product of the audit process is a report that
basically "accounts" for or evaluates the organization's performance. This
report helps hold policy makers, administrators, and their respective programs
accountable to their constituents.
Perrow (1986) believed the major contribution of the institutional school
is its analysis of the environment, e.g., institutional values. Auditors can focus
their procedures by understanding the evolving values of representative
government, checks and balances, and accountability.
The institutional concept of societal values and their relationship to the
audit process can be further analyzed with an example. If the Orange County
auditor knew that the value of checks and balances for California counties had
"drifted" over time (Perrow, 1986), then the auditor may have taken other
actions to disclose the risks of the cash and investment pool. The additional
risk of the Treasurer, in essence, having no accountability to policy makers
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and constituents, would have been targeted. As a result of the lack of
accountability, the Treasurer apparently was able to invest in very risky
securities that were not in accordance with California State Government Code.
One major violation of the Government Code was establishing a portfolio
objective of increasing yield at the expense of safety. As evaluators of public
policy, auditors should be aware of the evolution of investment policies and
report when administrators and elected officials have practices that conflict
with those policies. The evolution and history of institutional values and limits
should be included in a theoretical framework used to develop government
auditing standards.
North's (1990) focus was not on values and the evolution of institutions,
but on the interaction of institutions. He defined institutions as constraints
humans devise to shape their interactions and believes organizations are
created to take advantage of the opportunities presented by institutions in
shaping the development of economies. Like Perrow (1986) and other
institutional researchers, North believes the present and future are connected
to the past by the continuity of society's institutions. However, he also noted
that institutions are either formal or informal. His interests were in formal
constraints, such as rules that human beings devise, and informal constraints,
such as conventions and codes of behavior.
North's (1990) concept of institutions affecting the performance of the
economy by their effect on the costs of exchange and production is similar to
Perrow's (1986) concept of functions affecting institutional structure. The
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reason is institutions, along with economic theory, determine the opportunities
in a society. Organizations are created to take advantage of those
opportunities; and as those organizations evolve, they alter the institutions.
The concept of organizations altering institutions is similar to Perrow's (1986)
concept of functions determining the structure of organizations.
Institutions incrementally change through the perceptions of
entrepreneurs in political and economic organizations who see the possibilities
of doing better by altering the existing institutional framework. North (1990)
argues that only when we understand modifications in the behavior of the
actors can we make sense out of the existence and structure of institutional
change. He uses rational choice theory to analyze two particular aspects of
human behavior: (1) motivation and (2) deciphering the environment. Agency
theory is an economically based rational choice theory. Agency theory and,
specifically, the agent's motivation to perform his or her duties for the principal,
are dynamics that will be analyzed in the next section.
An analysis by Allen and Caillouet (1994) determined how institutional
and impression management strategies potentially shape stakeholder(s)
attitudes regarding organizational legitimacy. These authors described the
relationship between stability and legitimacy; they stressed the power of
shared implicit understandings. The environment is viewed as non-local; and
taken-for-granted scripts, rules, and classifications are seen as important
forces guiding a corporate actor's behavior. A key premise of neo-
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institutionalism is that conformity to social rules within the external institutional
environment potentially enhances a corporate actor's legitimacy.
The concept of legitimacy presented by these authors is relevant during
the audit process. Obviously, if formal institutional values place a constraint
on government organizations that does not allow them to be involved in certain
activities, then it should be the financial auditors' duty to evaluate whether that
policy constraint is followed. The involvement of Orange County's investment
pool in highly leveraged, risky investments would have been constrained and
not consistent with formal codes that legitimize investment policies.
Berger and Luckman (1966) also believe like Allen and Caillouet that
legitimization is a useful apparatus of institutions. However, Berger and
Luckman's edifice of legitimization is built upon language and uses language
as a principal instrument. They believe the function of legitimization is to make
objectively available and subjectively plausible the values, norms, and rules
that have been institutionalized. Berger and Luckman's concept of language
as being a big part of legitimization is very applicable to the audit process.
The language used in cash and investment transactions can be very
confusing, but seemingly legitimate. Language and concepts such as,
matching vour investments, a latter portfolio, and hedging vour position are
very intimidating, but curiously legitimizing. However, it is important for
evaluators of public policies to look beyond the language to challenge the
transactions, especially considering the institutional dynamic of language.
This responsibility would mean in the area of cash and investment that
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transactions would be evaluated by considering the following (in order): (1)
safety, (2) liquidity, and (3) yield.
Carrier and Marsh (1995) performed a recent study considering
investment behavior; they argued that institutional theory could be used to
predict investment behavior. The institutional view is that investments are
responsive to economic conditions and financial flows which are in turn based
on the institutions and practices of commerce and banking. These authors
have distinguished between two types of change— legislated and evolutionary.
Carrier and Marsh cite Hyman Minsky's (1993) institutional investment theory.
Minsky (1993) considers the mode of investment behavior that rules at any
time to depend upon institutional relations, the structure of financial linkages,
and the history of the economy.
4.5 AG ENCY TH EO R Y
As previously discussed, institutions are changed by organizations and
functions. Institutions provide economic opportunities for organizations.
Government organizations are shaped and changed by elected officials,
administrators, and constituents. Agency theory can provide unique insight
into information systems, outcome uncertainty, incentives, and risk; these are
elements that change government organizations. Eisenhart (1989) concluded
that agency theory is useful and has been supported by empirical evidence,
particularly when coupled with another theory. Agency theory coupled with
institutional theory can be used to explain and analyze dynamics within
organizations that eventually will change institutions.
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Agency theory studies the relationships between one party (the
principal who delegates work) and another party (the agent who is to perform
the work). Agency theory is concerned with resolving three problems in this
relationship. The first problem is when the goals are different between the
principal and the agent. The second problem deals with the difficulties and
costs born by the principal to verify what the agent is actually doing. A third
problem arises from adverse conditions caused by the principal that limit
economics, efficiencies, and effectiveness in the agent’s performance.
Lambert, Larcker, and Weigelt (1993) recently studied the effects of
organizational incentives on employee performance. One organizational
theory studied was “tournament theory,” which is a form of agency theory
(Lambert, Larcker, and Weigelt, 1993). The high performers move to the next
level. The study identified methods to maintain motivation at each level.
“Managerial power theory” is a form of institutional theory (Lambert, Larcker,
and Weigelt, 1993). The manager's incentives are derived from his or her
ability to exert influence on organizational decisions and, ultimately, the
compensation committee. Agency theory was the third theory studied.
The level of an executive's compensation is an increasing incentive for
the executive's performance. The dynamics of compensation and incentives
are areas of interest to auditors.
Managerial power theory may be applicable to the Orange County
bankruptcy. Orange County’s investment pool had a high percentage of
outside investors. In fact, several municipal governments from the San
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Francisco Bay area in California invested in the Orange County investment
pool. Many of these outside investors may have felt that the Orange County
cash and investment pool was an institution. The Treasurer's incentive was
managerial in nature; he could exert his influence on the organization and,
ultimately, he was rewarded with power and compensation. Unfortunately, his
investment practices were too risky (Sjoberg, 1995) and eventually the market
changed. Several researchers have studied risk using agency theory. This
use of agency theory is very applicable to the audit process.
Several areas of risk are associated with the operation of government
organizations. One risk is that government services will not be properly
provided and government organizations will be held accountable. To verify
this point, one would only have to review a city or county's financial statements
and note that a lot of resources are devoted to risk management. Another
form of risk is the loss of public support as a result of bad operating practices.
This loss of public support intersects societal values on how government
institutions should protect public resources and be held accountable.
Eisenhardt (1989) describes the risk-sharing problem as one that arises
when cooperating parties have different attitudes towards risk. The way in
which government organizations protect against the risk of losing public
resources is an area of great interest to the auditor or evaluator of public
policies.
The proper use of public resources is an institutional value in today's
society. Government organizations share the risk of protecting their precious
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resources among policy makers and administrators. The principals in this
relationship are the citizens of the government organization. The agent(s) of
this relationship are the policy makers and administrators of the government
organization. To ensure that agents follow the direction of the principals,
positivist researchers have developed governance mechanisms that limit the
agent's self-serving behavior (Eisenhardt, 1989).
An example of a governance mechanism is the California Government
Code directing municipalities in their cash and investment practices. The Code
has been updated to reflect recent Senate bills that were passed in response
to the Orange County bankruptcy. Several of these Code sections are
designed to reduce risks associated with cash and investment transactions.
Code sections that have been recently updated are 53600 and 53601
(California Government Code, 1996). Section 53600 requires that persons
and governing bodies authorized to make investment decisions are fiduciarily
responsible subject to the prudent investor standard. A prudent investor is
expected to be familiar with investment matters and, also, expected to
safeguard the principal and maintain the liquidity needs of the municipality.
This section also declared that the deposit and investment of public funds by
local officials and local agencies are issues of statewide concern. This section
sets limits on any investments of more than five years, reverse repurchase
agreements, and repurchase agreements. Section 53601 now prohibits
investing in inverse floaters, range notes, or interest-only strips that are
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derived from a pool of mortgages. Limits on other derivative investment
products are also established in this section.
The risks associated with these transactions include operating, market,
credit, and legal risks (GASB, 1997). Operating risk is the risk of losses
occurring as a result of inadequate systems and control, human error, or
management failure. Market risk is the exposure to changes in the market,
such as a change in interest rates or a change in the price or principal value of
a security. Credit risk is the exposure to the default of another party to the
transaction (the counterpart). Legal risk is the exposure of a transaction being
prohibited by law, regulation, or contract. The auditor of cash and investments
has an additional detection risk concern. Detection risk is the risk that the
auditor will not detect a material misstatement that exists in a financial
statement assertion.
Agency theorists also have analyzed methods to reduce risk associated
with the principal/agent relationship. A lot of the research is centered around
the contract between the principal and the agent. Eisenhardt (1989) studied
the risk aversion of both the principal and the agent and arrived at two
propositions. Proposition 5: The risk aversion of the agent is positively related
to behavior-based contracts and negatively related to outcome-based
contracts. Proposition 6: The risk aversion of the principal is negatively related
to behavior-based contracts and positively related to outcome-based
contracts.
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Another element of dealing with risk is whether the agent is informed or
uninformed about the contract and the expected tasks. Sobers (1993) study
analyzed whether the principal prefers an informed agent or uninformed agent
when contracting. The answer depends on the number of task outcomes. If
there are only two possible outcomes, then a risk-neutral principal prefers an
informed agent to an uninformed agent regardless of when the agent acquires
information. Sobel's (1993) model illustrates the same basic tradeoff that
appears in other researchers' models, including better information is good
because it allows the agent to make better decisions, while improved
information may be bad because it increases the incentive problems that the
principal must solve. Obviously, the risk associated with transactions between
the principal and the agent, in most cases, will be inversely related. However,
what about the risk associated with the agent protecting and enhancing
resources of the entity?
To evaluate performance risk with the agent, the principal will determine
outcome measures to apply. These outcome measures should be achievable
so that the agent is motivated to perform his or her duties. Similar to the
findings of Lambert, Larcker, and Weigelt (1993), there has been a lot of
research in the areas of performance and rewards. Garen (1994) recently
analyzed a simple principal-agent model to determine how well it explains
variations in compensation. His findings are consistent with the intuition that
there are tradeoffs between incentives and stability. He found that pay-
performance is less sensitive when the organization is unstable.
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Designing contracts that have outcome objectives is consistent with
Osborne & Gaeblers' (1992) observations that some government
organizations have been, and that more should be, utilizing entrepreneurial
practices such as outcome measures. Kirlin (1984) also suggests a broader
framework for evaluating government performance. Kirlin bases this
framework on his definition of government as the institution of society with
singular obligations to facilitate societal choice making and action. He
emphasizes that capacity for choice making and action is not synonymous
with service delivery. He subscribes to moving from a logical positivism
philosophy to a pragmatic philosophy of science. He agrees with institutional
researchers that government policies are evolutionary. Therefore, choices are
made within the constraints of previous choices. Kirlin advocates theory
construction that incorporates the choice-making role of the political system as
opposed to only service provision.
Therefore, if government institutions are moving towards the rational,
choice-making, entrepreneurial paradigm, agency theory will provide insight on
how to evaluate this new science. Evaluation is necessary in a principal/agent
relationship because it is fraught with problems of cheating, shirking of duties,
and limited information. Perrow (1986) describes the use of monitors to
evaluate the relationship between the principal and the agent.
Perhaps a monitor could be an activist auditor as described by Wheat
(1991). His description of an activist auditor is a performance auditor
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evaluating whether government organizations are effectively operating in this
increasingly complicated government environment.
Wholey and Hatry (1992) also believe that performance monitoring of
public programs, similar to Perrow’s (1986) view, is feasible and useful. As
part of a cycle of implementing public policy, performance monitoring and
regular reporting can inform elected officials and citizens and keep them
involved in governance. Wholey and Hatry (1992) suggest a major difficulty
with performance monitoring is the development of appropriate monitoring
systems. An appropriate performance monitoring system will require multiple
performance indicators. Wholey argues that in order to reduce the number of
indicators and discourage "creaming,1 1 proper identification of important quality
and outcome dimensions is essential.
A major problem with agency theory is it is generally used to analyze
problems with agent performance. However, problems may be associated
with the principal, management, or structure (Perrow, 1986). This fact is
another reason why agency theory coupled with institutional theory provides a
theoretical framework to design audit procedures. The auditor needs to be
able to detect when problems are the result of structural limits or design as
opposed to agent performance. Walters (1996) argues that the Orange
County bankruptcy was structural. Walters felt that California county
institutions are structurally inadequate and have limited accountability.
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4.6 CONCLUSION AND TRANSITIO N TO CHAPTER 5
This chapter has addressed development of the theoretical background
to aid in evaluation of the implementation of public policy. Entrepreneurial,
risk, institutional, and agency theories were considered. These theories were
chosen because they complement each other and provide differing insights for
improving the government financial audit model. A theoretical framework has
been developed in Chapter 5 from this set of theories.
Recent studies of entrepreneurial activities have provided a basis for
establishing a working definition for entrepreneurial activities for this research.
In addition, recent studies have compared conflicts between entrepreneurs
and democratic values. Also, recent studies in this area have provided
valuable observations on what kinds of entrepreneurial activities are working in
government organizations. This background is useful to the proposed model
in Chapter 5.
The risk models analyzed in this chapter provide this researcher with an
approach for dealing with entrepreneurial risk. In particular, the fraud risk
model is used in developing an entrepreneurial risk model. The six-step
approach of describing, assessing, responding, evaluating, documenting, and
communicating risky entrepreneurial activities is part of the model proposed in
Chapter 5.
The variety of concepts from institutional theory has provided a fruitful,
theoretical backdrop for this endeavor. The research performed regarding
institutional environment and values will provide useful information in
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developing additional audit procedures for acquiring a better understanding of
government organizations and environment. The studies conducted on
legitimization and how language is involved in this process help auditors
challenge whether transactions are authorized. The fact that government
institutions are ever changing and evolving through exchange transactions
initiated by organizations and functions help the auditor in identifying what
significant policies need to be evaluated.
As suggested by Eisenhardt (1989), agency theory is particularly useful
when coupled with a complementary perspective. Agency theory adds to the
theoretical framework for evaluating public policy. Its rational choice roots are
consistent with today's entrepreneurial approach to governance. Analyses
performed on compensation and rewards are also very helpful to developing
procedures for the audit process. Agency theory analyses of risk and risk
aversion are consistent with the societal values of checks and balances and
today's governance paradigm of entrepreneurship. The governance
mechanism emerging from positivist researchers is not a pragmatic theory, but
it is certainly useful to identifying and establishing workable government
regulations to evaluate.
Table 4-1 categorizes the theories and methodologies to be used in the
proposed audit model in Chapter 5.
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Figure 4-1
Theories and Methodologies
Audit Model Proposed in Chapter 5
Agency Risk
Institutional Entrepreneurship
(Original figure)
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CHAPTER 5
DEVELOPMENT OF AN IMPROVED FINANCIAL AUDIT MODEL
FOR GOVERNMENT ORGANIZATIONS
5.1 INTRODUCTION
This study has shown that government agencies are involved in
complex, risky transactions. Existing audit models do not effectively provide
guidance on how to audit and report complex and risky entrepreneurial
transactions. This chapter proposes a theoretical government audit framework
that incorporates complex, risky transactions typically associated with
entrepreneurial activities.
The proposed audit model enhances the existing model for AICPA
Audits of State and Local Government Units (ASLGU). This study described
ASLGU’s model in Section 3.3. ASLGU (AICPA, 1998) incorporates three
standard setting bodies and their auditing standards that are followed by
financial and government auditors. The three standard setting bodies and
their applicable standards are the AlCPA’s generally accepted auditing
standards (GAAS), the GAO’s generally accepted government auditing
standards (GAGAS), and the federal Single Audit Act, which is implemented
through OMB Circular A-133. Figure 3-1 describes the inter-relationships of
these standards.
These standards deal with three primary forces affecting the
government financial audit model. The three primary forces are accounting
policies, related internal control environment, and government mechanisms
over operations. The remaining sections of this chapter describe in greater
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detail these three forces and introduce entrepreneurial activity as another
force that affects government financial audits. This chapter conceptually
incorporates the four forces into a proposed government audit model and
illustrates how this model can be adjusted for different kinds of entrepreneurial
activities.
Blessing (1991) identified three changes in the government
environment that have caused an increase in performance audits. The
changes are shrinking government resources, changing auditing and reporting
standards, and the ever-widening “expectation gap” between users of
government audit reports and auditors. Government financial audits should
focus on significant and important areas and not impair the users of the audits.
Lindblom (1990) believes that society has difficulty dealing with problems
because of impairments that do not allow “lay” people to challenge and inquire
about systems. This chapter deals with closing “expectation gaps” and
impairments over auditing entrepreneurial activity.
Chapter 4 discussed theory construction in public administration. That
chapter concluded with a set of theories to be used in the proposed
government audit model. Table 4-1 placed bodies of theories into broad
categories using a network of models for the development of theory. Figure
4-1 summarized detailed theoretical categories and methodologies to be used
in this study’s proposed audit model. Figure 5-1 again summarizes these
detailed theoretical categories and methodologies along with the four primary
forces affecting the audit approach. This chapter unfolds by describing these
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forces and embedding them into the detailed theoretical categories and
methodologies.
Figure 5-1
Forces Affecting the Audit Approach
Theoretical Categories and Methodologies
Force Accounting Policies Internal Control Environment
Agency Risk
Institutional Entrepreneurship
Force Government Mechanisms Entrepreneurial Activity
(Original figure)
5.2 ACCOUNTING POLICIES
5.2.1 Background
Accounting policies of state and local government organizations affect
how auditors approach an audit. Each government organization establishes
its accounting policies based upon generally accepted accounting principles
(GAAP). The Governmental Accounting Standards Board (GASB) establishes
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GAAP for state and local government organizations (AICPA, 1998). According
to generally accepted government auditing standards, financial audits include
financial statements or financial-related audits (Bowsher, 1994). This study
focuses on the auditing of state and local government financial statements.
Therefore, this chapter’s proposed governmental financial audit model is
designed for state and local government financial statement audits.
Accounting policies can be akin to scoring a game. For example, in
tennis, special terms and methods are used to determine the winner of a
match. In a typical men’s grand-slam tennis tournament, players must score
four points and at least two points more than the other player, to win a game.
Points are scored 15, 30, 40, and winner of the game. The word “love” is used
when a player has not received any points in a game. To win a set, a tennis
player must win at least six games; and, sometimes, a tiebreaker is used when
both players win six games. Finally, a player must win three out of five sets to
be declared the winner of the match and progress toward the lucrative
championship title.
Similar to scoring a tennis match, accounting policies establish how a
government organization scores its financial position and results of operations.
Accounting policies use specialized language and terms, periods, and systems
and methods to determine performance.
Accounting policies affect an audit approach in several ways.
Accounting policies are rules used to measure financial position and results of
operations in a given accounting cycle (GASB, 1999). The government
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accounting cycle is generally one year. For California’s municipal government
organizations, the fiscal year ends on June 30th. Accounting policies direct
government organizations on how to record transactions. Transactions must
be accurately accounted for since they affect the resources of an organization.
To capture financial data for the organization’s accounting policies, internal
accounting systems are created and maintained. The auditor needs to
understand and test these internal accounting control systems. Understanding
and testing of internal accounting systems are forces affecting the audit
approach and are analyzed in the next section.
The complexities of accounting policies also are forces that affect the
audit approach. GASB Statement No. 31, Accounting and Financial Reporting
for Certain Investments and for External Investment Pools, is a complicated
standard that affects municipalities’ accounting policies (GASB, 1997). The
accounting standard changed the way state and local governments record
their investments. At year-end, municipalities must now record their
investments using fair values rather than amortized costs. In addition, the
standard also required organizations that have external investment pools
(organizations that have outside participants in their pools) to establish a
separate trust fund for the external portion of the pool. If an organization has
an internal investment pool, then many of the disclosure requirements for an
external investment pool still apply. In addition, this standard prescribes how
organizations account for investment transfers among funds.
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The Standard (GASB Statement No. 31) (GASB, 1997), also, has
several more detailed accounting and reporting requirements. The Standard
is complicated and investments can be at risk if the standard is not properly
and consistently implemented. An organization’s financial position and results
from operations are significantly affected by this standard. Auditors must
ensure organizations’ accounting policies properly implement GASB
Statement No. 31 and other important and far reaching statements.
As mentioned in Chapter 3, Governmental Accounting Standards Board
(GASB) has recently issued GASB Statement No. 34, Basic Financial
Statements and Management Discussion and Analysis for State and Local
Governments (GASB, 1999). This Statement is complicated and “far
reaching.” The Standard will affect how local municipalities account for and
report financial transactions. Several new internal accounting control systems
will need to be established to meet the requirements of GASB Statement No.
34.
One major requirement relates to financial reporting of infrastructure
assets (GASB, 1999). Changing from the modified accrual basis of
accounting to the accrual basis of accounting is another significant
requirement (GASB, 1999). Government organizations must establish new
internal accounting control systems to capture financial data on infrastructure
assets. It is anticipated that government organizations will need to develop
and add to their current accounting systems to convert from the modified
accrual to the accrual basis of accounting. These changes will have a
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significant affect on auditing approaches to state and local government
financial audits.
5.2.2 Theoretical Framework
An organization’s implementation of its accounting policies can be
studied using agency theory. As described in Chapter 4, agency theory
studies the relationships of one party (the principal) who delegates work to
another party (the agent). Agency theory is concerned with resolving two
problems in this relationship. The first problem is when the goals are different
between the principal and the agent. The second problem deals with the
difficulties and costs born by the principal to verify what the agent is actually
doing.
Shillinglaw and McGahran (1993) identified owners as principals and
managers as agents in their book, Accounting - A Management Approach.
For local government organizations, the owners are governing board members
and are representatives of their constituents (the shareholders). The agents
are administrators (managers), including the financial experts implementing
accounting policies. If our government institutions are moving toward the
entrepreneurial paradigm, agency theory, an economic theory, will provide
insight on how to evaluate this new paradigm. Evaluation is necessary in a
principal/agent relationship because that relationship is fraught with problems
of cheating, shirking of duties, and limited information. Perrow (1986)
describes the use of monitors to evaluate the relationship between the
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principal and the agent. Wheat (1991) believes an auditor can be an effective
monitor.
The following are some examples of where agency theory can be used
to analyze behavior in implementing accounting or auditing standards.
Agency theory can be used to determine that financial administrators are
recording transactions correctly. Government operations are often budgeted
using current available resources. Local municipalities prepare their budgets
by departments, funds, cost centers, and account codes. If an amendment to
the original budget is necessary, there are usually controls to ensure approval
is obtained. One control is simply having a dollar limit for budget items within
budget categories within the department (City of Los Angeles, 1999). Another
is obtaining the governing body’s approval for the amendment.
Agency theory can be used to analyze behavior between the principal
and the agent during the budgeting process. One audit study could simply be
analyzing the agent’s behavior if the budget for his department is too low. The
study could determine whether any of the principal’s objectives are being met.
Another study could be analyzing how a principal should react when the agent
circumvents certain budgeting controls. Should the principal withhold agreed-
upon incentives? Depending on the nature of the breach of confidence,
should the principal fire the agent? These are the types of accounting issues
agency studies have incorporated (Garen, 1994).
Agency theory can be used to study the preparation of financial
statements in accordance with the organization’s accounting policies. One
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study could be what are the incentives and disincentives for preparing the
financial statements in accordance with GAAP.
Economic based theory is also good for analyzing relationships
between the principal and agent. Sobel (1993) studied whether the principal
prefers an informed agent or uninformed agent when contracting. Sobel felt it
depended on the number of task outcomes. If there are only two possible
outcomes, then a risk-neutral principal prefers an informed agent to an
uninformed agent regardless of when the agent acquires information. The
model illustrates tradeoffs that often appear when an agent performs work for
the principal.
5.2.3 Conclusion
It is anticipated that organizational risks increase if a state or local
government organization does not implement GASB Statement No. 34.
Perhaps, the government organization may receive a modified opinion for their
published financial statements. A modified opinion, such as a disclaimer
opinion, could jeopardize the organization’s future federal funding. Non-
compliance with GASB accounting standards may also cause the
organization’s bond rating to decrease, thus causing interest rates to increase
(Fajardo, 1996).
This study is concerned about incorporating entrepreneurial activities in
the audit process. The focus of this study’s empirical research, in Chapter 6,
is surveying users and auditors of governmental financial statements about
auditing entrepreneurial activities. This study’s proposed government audit
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model incorporates agency theory. Agency theory is incorporated to relate
what is happening in practice within a theoretical framework.
5.3 INTERNAL CONTROL ENVIRONMENT
An organization’s internal control environment can also affect the audit
process. Chapter 3 emphasized that the internal control environment primarily
includes internal accounting and administrative controls (AICPA, 1998).
Internal accounting controls are those controls and processes that record
financial data; for example, the preparation and approval of time cards in a
payroll system. Internal administrative controls are those controls and
processes that maintain administrative data; for example, a program’s
eligibility system has income and place of residence data on participants. A
government organization’s internal control environment is an important force
that affects an auditor’s approach and must be included in any proposed audit
model.
Chapter 3 describes and discusses in detail aspects of the
organization’s internal control structure. GAGAS (Bowsher, 1994) and the
AICPA standards (1998) require the following.
Auditors should obtain a sufficient understanding of internal
controls to plan the audit and determine the nature, timing, and
extent of tests to be performed.
Four aspects of internal controls summarized in Table 5-1 are important to the
judgments made by auditors about audit risk (Bowsher, 1994).
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Table 5-1
Aspects of Internal Control
• Control Environment
• Safeguarding Controls
• Controls Over Compliance
• Control Risk Assessment
(Bowsher, 1994)
The audit approach to the internal control environment can be grounded
in risk theory. Osborne and Gaebler (1993) are not convinced of the
connection between risk-taking and effective public management. Osborne
and Gaebler (1992, p. xx) argue that the need to be more entrepreneurial
should not be interpreted as simply taking risks:
Many people also assume that entrepreneurs are risk-takers.
They shy away from the notion of entrepreneurial government
because, after all, who wants bureaucrats taking risks with their
hard-earned tax dollars. But, as careful studies demonstrate,
entrepreneurs do not seek risks, they seek opportunities.
Other studies of reform accept that risk-taking is a part of public
entrepreneurship but argue that this risk can be tempered. Bellone and Goerl
(1992) suggest that public entrepreneurial behavior should be accompanied
by a “civic-regarding” ethic that encourages citizen participation. Bozeman
and Kingsley (1998) studied risk culture in public and private organizations.
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These researchers observed that a riskier culture is positively related to the
willingness of top managers to trust employees and to the clarity of an
organization’s missions. Bozeman and Kingsley (1998, p. 109) also found
organizations with more red tape, weak links between promotion and
performance, and high involvement with elected officials tend to have a less
risky culture.
Eisenhart (1989) studied risk using agency theory. The risk is that the
agent (administrator) is not following internal accounting and administrative
control procedures developed by the principal (policy maker). In addition, as
discussed in Chapter 4, internal control risks can be studied using Statement
on Auditing Standards (SAS) No. 47 (AICPA, 1998). SAS 47, “Audit Risk and
Materiality in Conducting an Audit,” defines audit risk as the risk that the
auditor may unknowingly fail to appropriately modify his or her opinion on
financial statements that are materially misstated.
SAS 47 says the auditor needs to consider audit risk at the transaction
level because such consideration directly assists in determining the scope of
auditing procedures to use. SAS 47 says audit risk consists of (a) the risk
(consisting of inherent risk and control risk) that the transaction and related
assertions contain misstatements that could be material to the financial
statements and (b) the risk (detection risk) that the auditor will not detect such
misstatements. Therefore, the auditor must use guidance provided by SAS 47
when auditing the internal control environment.
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Table 3-6, Risk Factors for Government Financial Audits, provides
common risk factors that should be considered. Entrepreneurial risk is not
listed in the table. Section 5.5 discusses incorporating risks associated with
entrepreneurial activities in government organizations.
5.4 GOVERNMENT MECHANISMS
5.4.1 Background
Most corporate audits are financial audits that follow generally accepted
auditing standards (GAAS). According to the standards in GAAS (AICPA,
1999), financial audits are focused on verifying material dollar balances in an
organization’s financial statements. Governmental financial audits are
different because laws and regulations are established to guide organizations
with their operations. Laws and regulations are the government mechanisms
used to direct how resources should be spent.
As part of their study, Gupta, Dirsmith, and Fogarty (1994) used
institutional theory to identify laws and regulations as government
mechanisms. Their study focused on forces that shaped the structures that
organizations adopt for coordination and control. The researchers studied the
General Accounting Office's practices in performing non-financial audits; they
analyzed contingency and institutional theories in explaining how auditors
adopt best practices. Contingency theory posits that the task environment and
the technical nature of work shape the coordination and control of
organizational members. Institutional theory proposes that institutional
expectations and mechanisms influence coordination and control. Their 1994
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study found that most audits were accepted and that bureaucratic control
(government mechanisms) was just one reason for this success rate. Other
reasons included experience of the auditors, size of teams for each audit, etc.
Laws and regulations impact a governmental organization’s financial
statements. Governmental entities, because they are established by and
operate under numerous laws and regulations, are generally subject to many
more legal constraints than are their non-governmental counterparts (AICPA,
1998). The GASB also suggests that laws and regulations affect
governmental organization’s financial statements.
An important aspect of GAAP (generally accepted accounting
principles) as applied to governments is the recognition of the
variety of legal and contractual considerations typical of the
government environment. These considerations underlie and
are reflected in the fund structure, bases of accounting, and
other principles and methods set forth here, and are a major
factor distinguishing governmental accounting from commercial
accounting (GASB, 1999, Section 1200.103).
Chapter 3 discussed the GAO Auditing Standards and the Single Audit
Act of 1984. The chapter emphasizes that controls over compliance should
provide reasonable assurance that financial statements are free of material
misstatements resulting from violations of laws and regulations. To meet this
requirement, auditors should have an understanding of internal controls
relevant to financial statements’ assertions affected by those laws and
regulations. In addition, auditors should design tests to properly evaluate
internal controls over these administrative requirements.
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The 1984 Single Audit Act (1996) has additional standards for state and
local financial statement audits. Most of these standards relate to compliance
with laws and regulations. Financial statement auditors must determine
whether noncompliance with federal laws and regulations affect the
government organization’s financial statements. Any proposed state and local
financial audit model must include an approach that addresses laws and
regulations. The general area of laws and regulations would include federal
programs in accordance with the Single Audit Act and OMB Circular A-133,
and other areas as well, including local laws and ordinances, state codes, etc.
5.4.2 Theoretical Framework
Using institutional theory to develop the audit framework for
understanding the organization...its environment, history, values, limits, and
culture...should be beneficial in developing government auditing procedures.
As discussed in Chapter 4, an understanding of institutional structure and how
it relates to an organization can be helpful in the audit process. Institutional
structure has evolved over time. By simply understanding the historical
aspects of the institutions, their structure, and how government organizations
provide services within this framework, auditors can better design their
procedures to evaluate the implementation of public policies.
The process of institutionalization and the development of institutional
structure can be further analyzed by identifying societal values. The process
of institutionalization leads to development of organic growth, wherein the
organization adapts to strivings of internal groups and the values of the
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external society. By understanding key societal values and even limits in the
institutional environment, auditors will understand governmental organizations
better. Auditors can use this knowledge in properly selecting, designing, and
performing audit procedures.
For example, a public entrepreneur's risky investment strategies were
against societal values and limits in California’s governmental institutional
environment. Chapman (1996) concluded, after analyzing Orange County’s
bankruptcy, that public entrepreneurs must be prepared to face additional
constraints in order to protect the public from their possible poor decision
making. Constraining public entrepreneurs in investment areas is now
occurring in California. California Government Code Sections 53600-53700
have been revised to prohibit and limit certain investments and suggest
prudent investment operations (State of California, 1996).
5.4.3 Conclusion
The auditing of governance mechanisms is an important part of a
government financial audit. A government organization’s approach to
applicable governance mechanisms significantly affects its financial
statements. Unfortunately, auditors have not consistently audited governance
mechanisms. Hepp and Mengel (1992) found substandard government audits
performed by certified public accountants (CPA). The major reason for
substandard audits by CPAs is their unfamiliarity with both Government
Auditing Standards (GAO) and laws and regulations applicable to an
organization.
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5.5 ENTREPRENEURIAL ACTIVITY
Throughout this study, examples have been provided that show how
entrepreneurial activities have affected state and local government financial
statements. Chapter 2 labels the Orange County bankruptcy, special
financing districts, and performance measurement systems as entrepreneurial
activities. That chapter also emphasizes that these activities are not currently
being emphasized in the audit process. In today’s government environment,
such entrepreneurial activity should be emphasized in the audit process.
Therefore, entrepreneurial activity is one of the four forces included in the
proposed audit model.
As discussed in detail in Chapter 4, the rise of the public-sector
entrepreneur is found in the advent of tax limitation movements, declining
federal grants to state and local governments, and the growing fiscal crises
faced by governments at all levels of the federal system. The behavior of
public entrepreneurs must be evaluated in terms of administrative
responsibility if their actions are to be compatible with democratic values.
Four important characteristics of public entrepreneurs --autonomy, a personal
vision of the future, secrecy, and risk-taking -- need to be reconciled with the
fundamental democratic values of accountability, citizen participation, open
policymaking processes, and concern for the long-term public good
(stewardship) (Bellone and Goerl, 1992, pp. 132-133). Revenue crises have
made public policy goals relatively less important. Revenue generation is
changing the relationship between administrators and citizens. For example,
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user fees, redevelopment agencies, off-budget enterprises, investment
revenues, tax-increment financing, and development fees can be seen as
measures to avoid voter approval and, thereby, increase the autonomy of
public officials and administrators. Together with privatization, these
measures contribute to the autonomy and discretion of public entrepreneurs
while often making public accountability more difficult. Because the public
sector’s bottom line is hard to measure, public accountability is most often
attempted by measuring inputs or regulating administrative processes. Only
by testing entrepreneurial vision through a meaningful public participation
process can public administrators and others ensure that public
entrepreneurship is compatible with the values of democratic participation
(Bellone and Goerl, 1992, p. 134)
Starting in 1998, California’s economy has been thriving. California
government organizations have been reporting record surpluses. Is there
entrepreneurial activity in this environment? Are government organizations
motivated to balance their budgets with risky, complex entrepreneurial
transactions? The answer is, “yes,” because organizations are in the process
of reinventing themselves (Osborne and Gaebler, 1993); they are creating
enterprising organizations to serve the public. Chapter 2 provides an example
of three government organizations creating a joint powers agreement to build
a baseball stadium. The stadium’s bonds are expected to be paid from
proceeds of any sales tax revenue generated by the stadium. These kinds of
risky, complex entrepreneurial transactions should be separately considered
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during the audit process. The fact these transactions are considered still may
not mean they will be audited. There are a lot of factors that go into an
auditor’s judgment on whether they should be audited, including the most
important factor...the auditor’s professional judgment. But, at the very least,
they should be separately considered during the audit process. Therefore,
entrepreneurial activity should be one of the forces affecting an auditor’s
approach to state and local government financial audits.
5.6 ASSESSED LEVELS OF RISK
This chapter has identified four forces that affect state and local
government financial statement audits. These forces have been related to
applicable theoretical frameworks. Auditors need to assess the risk of these
forces when considering them during audits. Auditors should assess
accounting policies, internal controls, governance mechanisms, and
entrepreneurial activities using the AICPA model for assessing control risk.
After obtaining an understanding of the internal control environment, the
auditor assesses control risk for the assertions embodied in the account
balance, transaction class, and disclosure components of the financial
statements. Control risk is defined by Statement on Auditing Standards (SAS)
No. 55, as amended by SAS No. 78, as the risk that a material misstatement
that could occur in an assertion will not be prevented or detected on a timely
basis by the entity’s internal control (AICPA, 1998, pp. 35-37).
Control risk is generally assessed as either maximum, moderate, or
low. Control risks are assessed at maximum when it is believed some or all
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assertions are unlikely to be effective or evaluating their effectiveness is
inefficient. Alternatively, for purposes of audit efficiency, the auditor may wish
to assess control risk below maximum (moderate) by performing tests of
controls. The auditor may seek a further reduction in the assessed level of
control risk for certain assertions. In such circumstances and the fact there is
available evidential support, the auditor may perform additional tests of
controls to lower the assessed level of control risk to low.
The method of assessing internal control risk can be used to evaluate
the four forces affecting the auditor’s approach. However, the ranking of the
four forces affecting government financial audits is different than ranking risk
related to management assertions. Maximum will simply mean this is a high-
risk area and auditors should concentrate their effort in the area. Therefore,
for the proposed model, the term “maximum” is changed to “high” ievel of
assessed risk. The term moderate still means moderate level of assessed
risk. The term low means low level of assessed risk. Much like the AICPA
control risk approach, concentrating the audit effort should reduce a high level
of assessed risk. For example, if the organization is involved in an
entrepreneurial activity, the auditor may want to spend time understanding the
transaction and ensuring that it is properly reported in the financial statements.
The ranking of the forces between maximum, moderate, and low risk will be
helpful in deciding where to concentrate auditor resources and determining the
auditor’s approach and methodology.
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5.7 PROPOSED AUDIT MODEL
This study has discussed several reasons why there is need to improve
our state and local government financial audit model. The significant reasons
discussed have been the changing government environment, the new
reporting model, and the increased use of entrepreneurial activity. Blessing
(1991) identified three changes in the government environment that have
caused the increase in performance audits. The changes are shrinking
government resources, changing government auditing standards and
generally accepted accounting principles for governments, and the ever-
widening "expectation gap" between users of government audit reports and
auditors (Blessing, 1991).
The “expectation gap” between users of audit reports and auditors is
very important. Many users of financial audit reports believe that auditors are
actually doing a lot more work. Harrell (1998) wrote about the lawsuit filed by
Orange County against their auditors. Their auditors, KPMG Peat Marwick,
were accused of failing to warn the County of risky derivative investments.
The auditors were also accused of failing to discover illegal transfers of cash
and investments among accounts. Orange County expected that their
auditors should have exposed the Treasurer’s risky investment practices.
Niesner (1999) observed that other trends influence the business of
local government auditing. These trends are driven by changes in the
government environment, including diminished resources, increased
competition within government for limited resources, competition with private
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industry, infusion of technology, process reengineering, and the demands for
increased accountability (Niesner, 1999, p. 33). Niesner also noted that local
government auditing would continue to evolve in response to this rapidly
changing environment.
This study’s proposed government auditing model builds upon Figure
5-1. That figure shows four forces affecting most government organizations.
The forces include accounting policies, internal control environment,
government mechanisms, and entrepreneurial activity. These forces are
linked to applicable theoretical frameworks. Figure 5-2 has labeled these
forces as internal forces and, also, incorporates the concept of risk in the
model.
The forces that affect a government financial audit predominately are
internally generated. Other forces that affect government financial audits,
including external ones, are discussed in Chapter 7. However, this study is
focused on internal forces.
Accounting policies are established within the organization. The
internal control environment is developed and maintained within the
organization. The control environment to ensure adherence to government
mechanisms is developed and maintained within the organization. Finally, the
conceptualization of implementation of entrepreneurial activity is generally
done within the organization.
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Figure 5-2
Proposed
Government Audit Model
Internal
Control
Environment
Accounting
Policies
20 20
40
40
80
80'
Degrees
Of Risk
(DOR)
20% Low Moderate High 60%
80
80
40
Government
Mechanisms
Entrepreneurial
Activity
Legend:
% = Value of Responses
(Original figure) DOR = Risk to Auditor
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The internal forces are presented in four quadrants. The degrees of
risk are presented in the proposed model as a “bulls-eye.” Conceptually,
depending on the nature of the government organization, the “bulls-eye”
moves among the quadrants. For example, Figure 5-3 would indicate a large
government organization that is involved in significant entrepreneurial
activities. These activities may also have been identified and audited in
previous years. A large municipality would have several significant state and
federal grants. Several California cities and counties fit this profile. Therefore,
the “bulls-eye” should hit the center circle equally because its risk is evenly
distributed among the internal forces.
Figure 5-4 provides another example where the “bulls-eye” is between
the left two quadrants. A grant specific audit of a government program would
fit this profile. In a grant specific audit, the auditor’s focus is on providing an
opinion on the program’s financial statements and reporting on compliance
with laws and regulations (Chait, 1995).
As mentioned in Section 5-6, a high-assessed level of risk means
auditors should spend audit resources in the area. If the organization is
involved in a significant entrepreneurial transaction that has not been
previously audited, then the proposed government audit model can be
adjusted to illustrate this situation. Figure 5-5 shows this kind of situation,
where the “bulls-eye” would be hit by the forces of accounting policies and
entrepreneurial activities. Chapter 2 provided examples of entrepreneurial
transactions that fit this profile (state and local government organizations that
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are involved in risky investment transactions, special financing districts, or
performance measurement systems). The additional audit procedures that
would be performed vary among these examples. Understanding the
transactions, stakeholders, risks, and how to report the transaction are
common audit procedures.
5.8 CONCLUSION AND TRANSITION TO CHAPTER 6
This chapter introduced four internal forces that affect state and local
government financial audits. The internal forces - accounting policies, internal
control environment, government mechanisms, and entrepreneurial activity -
are related to applicable theoretical frameworks. Figure 5-2 illustrates this
study’s proposed audit model. The model is then adjusted in Figures 5-3, 5-4,
and 5-5 for different government audit organizations and situations.
It was emphasized that three of the internal forces are already included
as major audit areas of the AlCPA’s Audit of State and Local Governmental
Units (ASLGU) (AICPA ,1998). Those forces are accounting policies, internal
control environment, and government mechanisms. However, these forces
have not been previously related to theoretical frameworks. Also, they have
not been illustrated in a model similar to Figure 5-2. In addition, the ASLGU
does not identify or describe entrepreneurial activity.
It should be remembered that state and local government auditing has
been “done” but not analyzed as a scientific activity. The “art of auditing” was
supposed to be acquired by imitation, by doing what an expert did, by imitating
the auditors in the field (Schandl, 1978). Until recently, beyond basic integrity,
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there has been very little theory about auditing. Also, there have been
conflicting definitions of auditing as a discipline. Audit activity is an evaluation
process. Evaluation is a comparison, resulting in an opinion or judgment. A
comparison implies the existence of a state of affairs (a model) and the
existence of another (actual, possible, or imaginary) state of affairs. In the
process of evaluation, both situations are considered and, from viewing them
concurrently, auditors arrive at one of several conclusions. Schandl (1978,
Chapter 1) provides this definition, “Auditing is a human evaluation process to
establish the adherence to certain norms, resulting in an opinion (or
judgement).” This definition has been incorporated in the proposed audit
model.
This study has shown that entrepreneurial activities are common in
California’s state and local agencies. Chapman (1999) recently noted in his
paper - Local Government, Fiscal Autonomy and Fiscal Stress: The Case of
California - that Proposition 13 caused many unforeseen consequences. One
consequence is local government’s entrepreneurial activities have become
important. Chapman noted that in many of these cases, the “deals” are very
complex; and not all details are revealed to the public and they are technical in
nature. He, also, noted that these techniques can generate large sums of
money for the jurisdiction; but it must be remembered that they are risky.
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Figure 5-3
Proposed Government Audit Model
Big County or City
Internal
Control
Environment
Accounting
Policies
20 20
40
40
80
80'
Degrees
Of Risk
(DOR)
20' Low 60% Moderate High
80
80
40
Government
Mechanisms
Entrepreneurial
Activity
Legend:
% = Value of Responses
(Original figure) DOR = Risk to Auditor
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Figure 5-4
Proposed Government Audit Model
Grant Specific Organization/Program
internal
Control
Environment
Accounting
Policies
20 20
40
80
80-
Degrees
Of Risk
(DOR)
1 0 % Low Moderate High
80
40
Entrepreneurial
Activity
Government
Mechanisms
(Original figure)
Legend:
% = Value of Responses
DOR = Risk to Auditor
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Figure 5-5
Proposed Government Audit Model
Entrepreneurial Government
Internal
Control
Environment
Accounting
Policies
20 20
40
80
80'
Degrees
Of Risk
(DOR)
Moderate Low High 90' 60%
80
80
Government
Mechanisms
Entrepreneurial
Activity
Legend:
% = Value of Responses
(Original figure) DOR = Risk to Auditor
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This study has argued that there is an “expectation gap;” users of audit
reports expect that entrepreneurial activities are being audited. Unfortunately,
as the Orange County bankruptcy case showed, its financial auditors may not
have been auditing the Treasurer’s risky investment schemes. Chapter 6
describes this study’s research problem, expectations, and methodology. It
includes survey instruments designed for both users and auditors of state and
local governments regarding entrepreneurial activities and internal forces
within the proposed government audit model.
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CHAPTER 6
RESEARCH PROBLEM, EXPECTATIONS,
DESIGN, AND METHODOLOGY
6.1 INTRODUCTION
This study addresses how state and local government financial audit
model can be improved. The study’s approach has been to identify and
understand major audit areas (forces) of the existing model and to suggest
changes. As described in Chapter 5, important audit areas in the existing
model are accounting policies, internal control environment, and government
mechanisms. The study notes that these areas appear to be the most
important ones of the existing model; they are forces that affect a government
audit. In addition, this study suggests adding entrepreneurial activity as a
fourth force affecting state and local government financial audits.
This Chapter describes the research problem, expectations, and
methodologies. Chapters 7, 8, and 9 are closely related because they refer
back to this Chapter’s research expectations and methodologies. Chapter 7
analyzes responses to surveys from auditors of government financial
statements. Chapter 8 analyzes responses to surveys from users of
government financial statements. Finally, Chapter 9 provides the study’s
conclusions and implications and offers suggestions for future research.
6.2 RESEARCH PROBLEM AND EXPECTATIONS
The AICPA audit and accounting guide, “Audits of State and Local
Governmental Units (1998)” is the audit model for state and local government
financial audits. This guide incorporates relevant accounting and auditing
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standards that are important to government financial audits. The guide does
not categorize standards into an easily understandable illustration or model.
In addition, the guide does not provide much background on state and local
governments’ operational environments. Specifically, government
organizations are becoming more entrepreneurial because of their
environments. In California, Berstein (1998) wrote that Proposition 13 has
caused some negative consequences; it has been blamed for a wide range of
unrelated events. Several of these events can be labeled, “entrepreneurial”
transactions. For example, Berstein argued that Proposition 13 caused the
Orange County bankruptcy because risky investment strategies were adopted
to compensate for reduced revenues.
Entrepreneurial governments typically have moved from centralization
to decentralization, from a monopoly to competition, from bureaucratic
mechanisms to market mechanisms, from politically-driven citizens to
customer-driven systems, from rule-driven organizations to mission-driven
organizations (Osborne and Gaebler, 1993). The current state and local
financial government audit model does not specifically address the
entrepreneurial trend being adopted by government organizations. Therefore,
the research problem is as follows:
Dissertation Problem Statement: How can independent financial
auditors incorporate entrepreneurial risk into the state and local
government financial audit model?
This study has several research expectations. Several of the study’s
expectations have been met. In Chapter 1, the study suggested a definition
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for entrepreneurial activities that government financial auditors could use.
Entrepreneurial activities were defined as “the risky use of public resources in
the creation of value for the people.” In Chapter 2, the study provided several
examples of entrepreneurial activities in local government organizations.
In arriving at a proposed theoretical audit model, the study develops a
fundamental framework. Chapter 3 provides background on the AlCPA’s
existing model. In addition, that chapter also provides background on the
Single Audit Act Model and GAO’s government auditing standards. Chapter 4
discusses use of a network of theories in arriving at a theoretical foundation.
That chapter suggests use of agency, risk, institutional, and entrepreneurial
theories. Chapter 5 relates this network of theories to major forces (areas)
that are in the existing model...accounting policies, internal control
environment, and government mechanisms (Figure 5-1). in addition, Chapter
5 introduces entrepreneurial activities as a fourth force affecting government
financial audits. Chapter 5 concludes by illustrating a proposed government
financial audit model (Figure 5-2). The chapter also shows how the model can
be adjusted for different kinds of audits.
This chapter provides a research methodology to support the study’s
proposed audit model. The proposed audit model incorporates
entrepreneurial activities as a potential force affecting government audits. An
expectation of this study is to confirm that all four forces are important areas
that affect government audits. Other expectations are to identify and confirm
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differences about the audit approach among auditors and users of audited
government financial statements.
6.3 RESEARCH DESIGN AND METHODOLOGY
6.3.1. Design
Several questions need to be answered about entrepreneurial activities.
First, research and practice must verify whether the areas derived from the
existing AICPA model are important enough to be labeled forces. Second, the
study should determine whether entrepreneurial activities in state and local
government organizations are an important audit force. Third, the study
should provide insight into how to adjust the proposed model when performing
different types of government financial audits.
As stated above, this analysis makes a first attempt at grounding audit
forces affecting government audits in a network of theories. This has not been
broadly done before. To assist in this endeavor, a model is created to help
measure what is actually done in government financial audits. Figure 5-2,
which is shown again below as Figure 6-1, was developed. The model
illustrates the forces affecting government financial audits and provides a
methodology to measure risk associated with the forces.
The model was created by modifying a similar model in the field of
psychology. Kolb, Rubin, and McIntyre (1979) created a model to measure
how people learn. The Learning Style Inventory (LSI) is a simple self
description test, based on experiential learning theory, that is designed to
measure an individual’s strengths and weaknesses as a learner in the four
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stages of the learning process (Kolb, Rubin, and McIntyre p. 38,1979). The
LSI measures a person’s relative emphasis on the four learning modes by
asking them to rank-order a series of four words that describe these different
abilities. This study’s model measures respondents’ beliefs on how
government financial audits should be conducted. The model uses four forces
affecting state and local government financial audits similar to four learning
modes in the LSI model.
Similar to the LSI model, the proposed government audit model offsets
opposing audit forces. This model design amplifies illustrated patterns created
from connecting values based upon survey results. The entrepreneurial
activities force is opposite from accounting policies force. The government
mechanisms force is opposite from internal control environment force. The
former forces are opposite because accounting is an evaluating force whereas
activities are an operational force. The other two forces are opposites
because control is a risk force whereas government mechanisms are an
institutional force.
The model measures the four forces using degrees of risk. Chapter 5
emphasized that generally accepted auditing standards labels risk as low,
moderate, or high. The model assigns numeric values to these risk concepts
based upon audit practice observations. If an auditor feels at least 90%
confident that an audit sample validates a balance or infers anticipated traits
about a population, then the auditor’s assessment of risk for the area would be
high. Auditor confidence between 60% to 90% is generally regarded as
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moderate assessed level of risk. Auditor confidence below 60% is generally
regarded as a low assessed level of risk. The model assigns anything below
20% auditor’s confidence a zero value. The reason is 20% auditor’s
confidence is not sufficient to validate a balance or infer much about a
population.
6.3.2. Methodology
Since a proposed audit model has been introduced, preliminary testing
is performed. This study’s objectives are to validate assumptions and beliefs
inherent in the model. Therefore, several propositions are examined. Survey
instruments were developed based upon this study’s propositions. The survey
instruments were sent to professionals familiar with state and local
government financial audits. Professionals chosen are both auditors and
users of government financial audits. The user group was further split
between government administrators and elected officials. By splitting the
sample among these three groups, survey results should be more informative.
For example, a comparison of answers could show expectation gaps among
the three groups surveyed.
The sample should be large enough to lend validity to the propositions
made for this preliminary study. The sample size is 60. Twenty surveys were
sent to each of the three groups previously described. It was anticipated that
not all surveys would be returned; however, there was no intent to generalize
the results to a broader population.
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Figure 6-1
Proposed
Government Audit Model
Internal
Control
Environment
Accounting
Policies
20 20
40
40
80
80-
Degrees
Of Risk
(DOR)
Moderate 60% 20% Low High
80
80
40
Government
Mechanisms
Entrepreneurial
Activity
Legend:
% = Value of Responses
(Original figure) DOR = Risk to Auditor
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To find experienced, knowledgeable professionals, two approaches
were used. The participants comprising the auditor group were selected from
both the California State Society of CPAs’ and the AlCPA’s state and local
government committees. A sample of 15 members was selected from the
California committee out of approximately 30 members. A sample of 5 was
selected from the AICPA committee out of approximately 15 members. The
participants comprising the user groups, administrators and board members,
were selected from the largest municipalities in California. Twenty instruments
were sent to the largest counties and cities in California. This sampling
approach provides a 30% coverage of this population grouping.
To help measure and plot responses, the survey questions are
numerically weighted from 5 to 1. A 5 agrees most to the question and a 1
agrees least to the question. A score of 5 generates a value of 100 on the
model; conversely, a score of 1 generates a value of 20 on the model.
Question values are then plotted on the proposed model. A pattern for each
group’s response is shown in Chapters 7 and 8. Chapter 9 provides an
illustrated model that plots the three groups’ responses and also plots
anticipated responses illustrated in Chapter 5. Chapter 9 also provides
conclusions and recommendations about this preliminary study.
The study uses several statistical tools to evaluate responses to the
instruments. To illustrate trends with graphs and charts, this study uses
univariate analysis (Sullivan and Rassel, 1995). A Chi-square test is used to
make comparisons among the sample groups (Sullivan and Rassel, 1995).
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6.3.3. The Study’s Propositions
Proposition 1 - That the AICPA Audit and Accounting Guide for State and
Local Governmental Units is the most important audit model.
Several different audit guides and standards are used to perform
government financial audits. This study seeks to determine which government
audit guide (model) is most often followed when performing state and local
government financial audits. The AICPA (1998) Audit and Accounting Guide
for State and Local Governmental Units is believed to be the most important
audit model.
Proposition 2 - Accounting policies are important internal forces affecting an
auditor’s approach.
The GASB has issued 36 accounting statements. Many of these GASB
statements have significant effects on the way transactions are recorded and
accounting systems designed. GASB Statement No. 34, the new reporting
model statement, has far-reaching effects. Oftentimes, government
organizations establish accounting systems to capture data that is required by
a GASB statement. Auditors often review and rely upon these accounting
systems. An organization’s accounting policies are an important internal force
affecting governmental financial audits.
Proposition 3 -An organization’ s internal control environment is an important
internal force affecting the auditor’ s approach.
An organization’s internal control environment includes both accounting
and administrative controls. Accounting controls are established procedures
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to control financial transactions of organizations. Administrative controls are
established procedures to control administrative transactions of organizations.
Statement on Auditing Standards Nos. 55 and 74 (SOP 98-3, pp. 7-8) requires
that auditors review the internal control environment. Auditors often rely on
the internal control environment for government financial audits. As a result,
an organization’s internal control environment is an important internal force
affecting governmental financial audits.
Proposition 4 - A government organization’ s compliance with laws,
ordinances, and regulations is an important internal force affecting the
auditor’s approach.
Administrative systems are established to ensure compliance with laws,
ordinances, and regulations (government mechanisms). Government
Accounting Standards (Bowsher, 1994) and the Single Audit Act 1984 (SOP
98-3) require auditors to understand and test compliance with government
mechanisms. If organizations are not in material compliance with government
mechanisms, the auditor’s opinion on the financial statements is modified
(SOP 98-3, p. 10). The organization’s compliance with laws, ordinances, and
regulations (government mechanisms) is an important internal force affecting
government financial audits.
Proposition 5 - Entrepreneurial Activities are an important internal force
affecting the auditor’s approach.
Government organizations are involved in risky use of public resources
in the creation of value for the people. Entrepreneurial transactions are often
significant, complex, and involve several government organizations. If
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transactions do not meet expectations, government resources are at risk. In
the case of Orange County (Orange County, 1998), the organization filed for
bankruptcy after losing approximately $1.7 billion in investments. Auditors
should understand and report these complex, risky transactions.
Entrepreneurial activities are an important internal force affecting government
financial audits.
Proposition 6 - The AICPA Audit and Accounting Guide for State and Local
Governmental Units does not effectively address how to audit entrepreneurial
activities.
The 1990s were labeled the decade of the public entrepreneur. Several
government organizations changed their operations to be more businesslike.
Many of the concepts observed and suggested by Osborne and Gaebler
(1992) about reinventing government have been incorporated into operations.
These concepts are entrepreneurial in nature and inherently more risky. The
AICPA Audit and Accounting Guide for State and Local Governmental Units
does not effectively address entrepreneurial transactions. Since most large
local municipalities are involved with material entrepreneurial transactions,
auditors should consider this area as an important internal force affecting
government financial audits.
Proposition 7 - Users of government financial audits expect auditors are
effectively auditing complex, risky entrepreneurial transactions.
An “expectation gap” exists between users of government financial
audits and auditors. The users believe that auditors appropriately understand,
effectively audit, and properly report material entrepreneurial transactions.
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The AICPA Audit and Accounting Guide for State and Local Governmental
Units (1998) does not discuss entrepreneurial transactions. Unfortunately, this
oversight was painfully apparent in the Orange County Bankruptcy case. The
auditors of Orange County were sued for a substandard audit; however, the
existing model still does not address entrepreneurial transactions. Yet, users
of governmental financial audits expect that auditors are effectively auditing
complex, risky entrepreneurial transactions.
6.4 IMPORTANCE OF STUDY
Auditors of government financial statements often mechanically perform
their audit procedures. For most audits of government financial statements,
this approach is enough. Recently, there has been a trend toward government
organizations becoming more entrepreneurial. Many government
organizations are changing their operations to be more businesslike.
Organizations want to stretch their resources and treat their constituents more
like customers. This change in philosophy and operational approach
oftentimes is very risky. Many of these transactions are complex and involve
several government organizations. The existing AICPA audit model does not
address entrepreneurial transactions. The importance of this study is to
establish entrepreneurial activities as an internal force affecting government
financial audits.
In addition, the importance of this study is to establish accounting
policies, internal control environment, and government mechanisms as other
important internal forces affecting government financial audits. The study also
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grounds these important government audit forces for the first time in a network
of administrative theories. Afterwards, the study proposes an audit model,
which can measure how different government financial audits are being
performed. This model can be used as a theoretical tool in illustrating how
different government financial audits should be approached.
Finally, this study shows an “expectation gap” between auditors and
users of government financial audits. Many users believe that auditors are
effectively auditing entrepreneurial transactions; however, this study has found
that very few procedures are being performed in this area. The study shows
this “expectation gap” and suggests ways to close it.
6.5 LIMITATIONS OF STUDY
This study has several limitations. The most important one relates to
the proposed audit model that has been created and tested. Since this is a
new model, a preliminary study is being performed to determine whether
assumptions and beliefs embodied in the model are correct. Therefore, the
population universe is intentionally narrowly defined among experienced
government financial management professionals. This approach is obviously
skewed, and conclusions reached may not empirically be duplicated when a
larger and wider population universe is sampled.
The study identifies four internal forces that affect government financial
audits. On any given financial audit, there may be other forces, not identified
in this study, that may affect government financial audits. There are other
external forces that affect government financial operations and their audits; for
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example, the global economy. The global economy can affect state and local
operations because government resources may increase or decrease as a
result of the global economy.
The study has grounded the proposed government financial audit
model in a network of administrative theories. The network of theories
consists of agency, risk, institutional, and entrepreneurial theories; these
theories are described and illustrated in Chapter 4. The network of theories is
related to important internal audit forces in Chapter 5 (Figure 5-1). The
preliminary work performed in this study does not extensively test any of these
administrative theories. This preliminary study suggests ways in which the
proposed audit model’s network of theories may be empirically tested in the
future.
6.6 CONCLUSION AND TRANSITION TO CHAPTER 7
The following is this dissertation’s problem statement:
Dissertation Problem Statement: How can independent financial
auditors incorporate entrepreneurial risk into the state and local
government financial audit model?
6.6.1. Summary
This study’s approach has been to include entrepreneurial activities
among the four important internal forces affecting government financial audits.
The three other important internal forces are accounting policies, internal
control environment, and government mechanisms. These four forces were
related to a network of administrative theories which form the base for the
study’s proposed state and local government financial audit model.
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Two survey instruments were developed (See Appendix A and B) to
solicit responses from both auditors and users of government financial audits.
A sample size of 60 was selected from a narrowly focused universe. The
universe consisted of experienced government financial management
professionals.
Since the study is proposing a new audit model, a preliminary study is
being performed. Seven propositions, rather than hypotheses, have been
identified and discussed. These propositions relate to the four internal forces
significantly affecting government financial audits. In addition, the seventh
proposition identifies an “expectation gap” between users and auditors of
government financial audits.
Chapter 7 summarizes the results of the surveys sent to experienced
government financial auditors. These surveys are preliminarily testing the
propositions discussed in this Chapter.
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CHAPTER 7
ANALYSIS OF RESPONSES TO SURVEY
FROM AUDITORS OF GOVERNMENT FINANCIAL STATEMENTS
7.1 INTRODUCTION
Chapter 5 introduced a proposed state and local government financial
audit model. Figure 5-2 illustrated the proposed model. The proposed model
incorporated four internal forces that affect government financial audits -
accounting policies, internal control environment, government mechanisms,
and entrepreneurial activities. These forces have been identified, developed,
and analyzed in this study. The methodology for testing the model is
described in Chapter 6.
To effectively test the proposed model, a survey was circulated to
experienced auditors and users of government financial statements. Chapters
7 and 8 summarize and analyze auditors’ and users’ survey responses,
respectively. The survey instruments were designed to assess the
propositions incorporated in the proposed model.
7.2 RESPONSE RATES
Table 7-1 shows that 60 surveys were sent to experienced auditors and
users of government financial statements. The auditors were selected from
two appointed government audit committees with a combined population of 40
members. The users were selected from the largest counties and cities in
California. The table shows a high overall 72% response rate from the sample
of 60.
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Table 7-1
Improving Government Audit Model
Survey Results
General Response Rate Auditors Users i otal
Surveys Received 15 28 43
Surveys Sent 19* 41* 60
Percentage of Total 79% 68% 72%
* A member of the “auditors” group felt she was more of a “user” and,
therefore, requested a user survey. Statistics were adjusted accordingly.
(Original table)
7.3 SURVEY QUESTIONNAIRE
The first five questions of the auditors’ survey, Appendix A, asked for
demographic information. Table 7-1 shows a 79% response rate from the
auditors. Table 7-2 summarizes the auditors’ demographic information. It is
important to note that these auditors are very experienced at performing
government financial audits.
The arithmetic mean for years of experience is 25. All of the
respondents possess the CPA license. Five of the respondents have the
additional Certified Government Financial Manager (CGFM) designation. The
Association of Government Accountants (AGA) issues this designation. The
designation represents additional training in the field of government financial
management. It should also be noted that these experienced auditors are
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members of two appointed government auditing committees. Therefore, the
respondents are more knowledgeable than the average government financial
auditor. The reason is they lead the profession in helping establish generally
accepted auditing standards for state and local government organizations.
Several of these respondents are in the process of updating the A.I.C.P.A.
audit guide (AGA, 2000).
Question 6 was designed to establish the A.I.C.P.A. Audit and
Accounting Guide for State and Local Governmental Units (AICPA, 1998) as
the existing audit model for local government financial audits. Out of a
possible value of 100, the auditors responded with 77% certainty that the
A.I.C.P.A. model is the most important audit model.
Question 6 - Presentation and Results
The questions were written using a Likert scale (O’Sullivan and Rassel,
1995) of 5 to 1. A score of 5 represents that the respondent strongly agrees
that the force is important and 1 represents that the respondent minimally
agrees the force is important. Therefore, an important force inherently has
either a high or moderate assessed level of control risk and a minimally
important force inherently has a low assessed level of control risk. Each
respondent’s answers were multiplied by a factor of 20. The reason for the
factor of 20 is to enable the plotting of respondents’ answers and better
illustrate observable patterns. Therefore, for each force, the highest possible
value was 100 and the lowest value was 20.
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Table 7-2
Improving Government Audit Model
Respondents’ (Auditors’) Background Information
Survey Years of
No. Experience Dearee License/Other
2 35 BA CPA
3 15 BA, GRAD CPA, CGFM
4 13 BS CPA
6 20 BA, GRAD CPA
7 25 BBA CPA
8 20 BA CPA
11 30 BS CPA, FOR
12 33 BS, GRAD CPA, CGFM
13 35 BS CPA, CGFM
14 30 BA CPA
15 30 BS CPA, CGFM
16 23 BS CPA
17 28 BS CPA
19 11 BS CPA, CGFM
20 20 BA, GRAD CPA
Mean 25
Legend:
BA Bachelor of Arts
BBA Bachelor of Business Administration
BS Bachelor of Science
CGFM Certified Government Financial Manager
CPA Certified Public Accountant
FOR Forensic Auditor
GRAD Master’s degree or higher
(Original table)
Question 6 (Appendix A) - The Guide is the most important audit model
for state and local government financial audits. The respondents’ relevant
number for this question is an arithmetic mean of 77.
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Questions 7, 8, 9, and 14 verify internal forces affecting audits of state
and local government financial statements. The four forces identified and
discussed in this study are accounting policies, internal control environment,
government mechanisms, and entrepreneurial activities. These four forces
were described as propositions 2 to 5 in Chapter 6.
To test propositions 2 to 5 and reject the null proposition that these
forces are not important, a chi-square analysis was performed. Table 7-3
presents the chi-square analysis. The test shows that the combined analysis
supports accounting policies, internal controls, government mechanisms, and
entrepreneurial activity as important forces affecting government financial
audits.
The AICPA Professional Standards addresses risk by instructing
auditors to perform tests to support an assessment below maximum risk
(AICPA, 1999, p. 332). Most of the respondents answered the questions from
neutral to strongly agree that auditors spend significant resources auditing
these forces. This study interprets “neutral” as supporting the force to be
important. The reason it is interpreted as important is the respondents needed
more information. These same respondents felt that these forces are
“important” for later questions, particularly, the questions that asked the
respondents to apply the forces to three audit scenarios.
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Table 7-3
Chi Square Analysis of
Important Forces Affecting
Government Financial Audits
Accounting
Policies
Internal
Controls
Government
Mechanisms
Entrepreneurial
Activity Total
Observed
Frequencies
Important 36.0 42.0 38.0 33.0 149.0
Not Important 7.0 1.0 5.0 8.0 21.0
4 M
43.0 43.0 41.0 170.0
Expected
Frequencies
Important 37.7 37.7 37.7 35.9 149.0
Not Important 5.3 5.3 5.3 5.1 21.0
43.0
4 M
43.0 41.0 170.0
Chi Square - 1
Important
individual
1.17 .56 .01 .74 2.4t
Not Important .55 3.49 .02 1.04 5.1C
1.72 4*05
.03
1.78 Z*5f
Analysis supports Propositions 2, 3, 4, and 5 and rejects applicable null propositions.
X2= 7.58, df = 3. p<.10 (6.251)
(Original Table)
Based on the responses to the Likert Scale, accounting policies,
internal control structure, government mechanisms, and entrepreneurial
activities are important internal forces that affect state and local government
financial audits. It is necessary to note that the analysis shows only one
respondent felt internal controls were not an important force.
The respondents’ arithmetic mean also shows that there are differences
in expectations among the auditor and user groups. The auditor’s combined
arithmetic mean is 53 points lower than elected officials and 27 points lower
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than the administrator group. The primary difference was that the auditors
said that entrepreneurial activities are not important audit forces. However,
both user groups, administrators and elected officials, said that entrepreneurial
activities are important audit forces. Thus, this type of difference supports this
study’s proposition 7 that there are expectation gaps among auditors and
various users regarding government financial audits. Table 7-4 Chi-square
analysis supports Proposition 7 with a 99.9% confidence level.
Table 7-4
Chi Square Analysis of
Entrepreneurial Activity Expectation Gap
Government Financial Audits
Not Total
Important Important
Observed
Frequencies
Auditors 7.0 8.0 15.0
Users 26.0
—
26.0
33.0
M
=
41.0
Expected
Frequencies
Auditors 12.1 2.9 15.0
Users 20.9 5.1 26.0
33.0 a il
=
41.0
Chi Square - Individual
Auditors 2.15 8.97
= 11.12
Users 1.24 5.10 6.34
3.39 14.07 = 17.46
Analysis supports Proposition 7 and rejects null proposition.
X2= 17.46, df =1, p < .001 (10.827)
(Original Table)
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Question 12 also supports proposition 7; it asks, “Do you believe
government financial auditors should audit and report on entrepreneurial
activities?” Sixty-seven percent of the auditors believe they should audit and
report on entrepreneurial transactions. Thirty-three percent responded “no” or
“do not know” to this question.
Although all three groups reported that accounting policies are an
important internal force affecting the audit, there is an expectation gap in this
area. Comparing arithmetic means, the elected officials scored accounting
policies 9 points higher than the auditors and administrators. Perhaps, the
elected officials believe that auditors should do more work in validating
account balances at year-end and ensuring that the organization is in
compliance with established accounting policies.
Question No. 10 was designed to find out what other areas the auditors
are spending a substantial amount of audit effort. This question generated 11
written responses summarized in Table 7-5. Several of the responses fit into
the four important internal forces (areas). The responses that merit further
discussion and analysis are as follows:
Analytical Review - Auditors do spend a lot of time performing analytical
review audit procedures. These procedures are chiefly designed to compare
account balances among years, budgets, or other analyses. Under the
proposed audit model, this area can be categorized under the accounting
policy force category.
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Financial statement preparation and disclosure - A government
organization’s financial statements are often prepared by its finance
department. However, in many instances, the auditor is engaged to prepare
the financial statements. This activity is not necessarily a force affecting the
auditor’s procedures, but it does involve a substantial amount of time and
resources.
Fraud, waste, and misconduct - Material fraud, waste, and misconduct can
be important areas of an audit. However, this area is generally addressed
during the auditor’s review of the internal control structure. Recently, a
Statement on Auditing Standards No. 82 (AICPA, 1997), ‘The Consideration of
Fraud in a Financial Statement Audits,” has clarified the auditor’s
responsibilities. Basically, the auditor is responsible for reporting fraud that is
material to the financial statements. Although substantial audit resources are
spent assessing the likelihood of fraud, under the proposed audit model, this
area is categorized under the internal control structure force.
Effectiveness of government programs - The respondents probably meant
that their audit practice conducts several government effectiveness and
efficiency audits. These audits are known as performance audits (Bowsher,
1994). Performance audits are not part of this state and local government
financial audit study.
Financing Reporting - This is an important area for government financial
audits. Under the proposed model, this area could be categorized in
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accounting policy or entrepreneurial activity forces. Financing organizations
are analyzed in section 7.4, and Figure 7-3 illustrates them.
Table 7-5
Improving Government Audit Model
Respondents’ (Auditors’) Audit Effort in Other Major Areas
Survey Question No. 10: You spend a significant part of your audit effort in
the following other areas:__________________________________________
■ Entrepreneurial activity_________________________________________
■ Federal grant compliance_______________________________________
■ Analytical review______________________________________________
■ Balance sheet auditing_________________________________________
■ Financial statement preparation__________________________________
■ Financial statement disclosures__________________________________
■ Explaining allegations of fraud, waste, misconduct__________________
■ Effectiveness of government programs___________________________
■ Analytical review impacts where effort is placed and can change
weighting____________________________________________________
■ Financing reporting____________________________________________
■ Other auditing procedures______________________________________
(Original table)
Question number 15 was “open-ended” and designed to solicit
responses from the auditors on typical audit procedures they have used
auditing entrepreneurial activities. Table 7-6 lists the procedures used. This
list of procedures is a good starting point, but it is not an all-inclusive list.
Most of the listed audit procedures address auditor’s risks associated
with entrepreneurial transactions. Discussing an entrepreneurial transaction
with attorneys and financial advisors is an audit procedure designed to
understand risks associated with these kinds of transactions. Analyzing
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applicable documents and results also covers the auditor’s risk in providing an
opinion on these kinds of transactions. Considering whether entrepreneurial
transactions will cause going concern issues entails audit procedures
designed primarily to cover the auditor’s risk.
Perhaps, the Statement on Auditing Standards (SAS) No. 82’s (AICPA,
1997) audit approach can be followed for entrepreneurial transactions. SAS
No. 82 considers material fraud during a financial statement audit (Mancino,
1997). The standard requires auditors to assess the risk of material
misstatements in the financial statement caused by fraud. It also requires
auditors to appropriately respond to the fraud risks, provides guidance on how
to evaluate tests designed to reduce fraud risks, and provides guidance on
communicating and documenting audit work performed.
SAS No. 82’s approach to fraud can be used for entrepreneurial
transactions in governmental organizations. Chapter 9, the concluding
chapter, illustrates how this can be accomplished, in addition to incorporating
the procedures listed in Table 7-6.
Table 7-7 summarizes questions 11, 13, 16, and 17. These questions
were designed to address a variety of issues discussed in this study.
Question 11 confirmed that government auditors do adjust their approach
among internal forces that affect the government organizations they audit.
Table 7-7 shows 100% of the respondents adjust their audit depending on the
organization they are auditing. Section 7.4 illustrates how to adjust the
proposed audit model for three different government financial audits.
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Table 7-6
Improving Government Audit Model
Respondents’ (Auditors’) Auditing Procedures for
Entrepreneurial Transactions
Survey Question No. 15: If applicable, please list typical auditing
procedures performed on entrepreneurial transactions.________
■ Discussions with attorney, financial advisors____________________
■ Review and analyze applicable documents and results___________
■ Financial statement disclosures - review_______________________
■ Obtain trustee statements-tie to general ledger_________________
■ Obtain agreements-review for unique provisions________________
■ Review fiduciary responsibilities and compliance________________
■ Review for proper accruals__________________________________
■ Review for contingencies____________________________________
■ Many local governments build/lease jail space and rent it to the
federal government. There is rarely any documents supporting the
price. In our audits, we identify actual costs and verify costs to
supporting documents, including review of contractor costs.______
■ Review of underlining documents_____________________________
■ Confirming of balances due__________________________________
■ Consideration of going concern_______________________________
■ Compliance testing_________________________________________
■ Verify year-end balances____________________________________
(Original table)
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Table 7-7
Improving Government Audit Model
Respondents’ (Auditors’) Survey Results
11. Does your audit focus adjust among accounting policies, internal
accounting control environment, government mechanisms, and other
forces depending on the organization you are auditing?
13. Do you believe the A.I.C.P.A. Audit and Accounting Guide for State and
Local Governmental Units effectively addresses entrepreneurial
activities?
16. Do you think GASB Statement No. 34, Basic Financial Statements and
Management Discussion and Analysis for State and Local
Governments, necessitates a change in our existing auditing model?
17. Do you think entrepreneurial activities can be covered with the audit
changes for GASB Statement No. 34?
Survey
No.
Audit
Focus
Adjust
Existing model
addresses
entrepreneurial
activity
Existing model
should change
for GASB 34
Include
entrepreneurial
changes with
GASB 34
2 Yes Blank Yes Blank
3 Yes Yes Yes Yes
4 Yes Yes Yes No
6 Yes No No Don’t know
7 Yes Yes Yes Yes
8 Yes Yes Yes Yes
11 Yes No No Yes
12 Yes No Don’t know Don’t know
13 Yes Don’t know No Yes
14 Yes No Don’t know Don’t know
15 Yes No Yes Yes
16 Yes No No Don’t know
17 Yes No Yes No
19 Yes Don’t know Yes Yes
20 Yes No Yes Don’t know
Summary
Yes 100% 27% 60% 47%
No 0% 53% 27% 13%
Don’t know
or left blank
0% 20% 13% 40%
(Original table)
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Question 13 responses supported proposition 6 in Chapter 6.
Proposition 6 states that the current AICPA audit model does not effectively
address entrepreneurial activities. Seventy-three percent of the auditor group
answered either “no” or they did not know. Answers to Questions 16 and 17
indicate a need to change the existing AICPA audit (model) guide because of
both entrepreneurial activities and the new GASB No. 34, which is the new
financial reporting model. A recent GASB Statement No. 34 satellite
videoconference (AGA, 2000, p. 60) emphasized that the AICPA was in the
process of updating the guide to include GASB Statement No. 34
requirements. GASB Statement No. 34 was introduced and discussed in
Chapter 3, Section 3.5.
7.4 APPLICATION OF PROPOSED AUDIT MODEL
This Section applies the tested model. The proposed audit model was
introduced and discussed in Chapter 5 and for the auditor group, it was
empirically tested in this Chapter. The last three questions in the survey
instrument apply the proposed audit model. The survey instrument inquired as
to how auditors balanced their audit effort among the four interna! forces
affecting government financial audits for three different scenarios. The
auditors were asked for each scenario to respond using the Likert Scale
previously described. The auditors’ answers were valued and an arithmetic
mean was calculated to facilitate the plotting of answers on the proposed audit
model.
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Question 18 of the auditors’ survey instrument inquired as to how
experienced auditors approach large, local government organizations. Large,
local governments were defined as a recurring large city or county financial
audit that has the usual general government services and enterprise funds,
receives federal funds that qualify for a Single Audit, and has at least one
major entrepreneurial transaction. The question used the four audit forces as
a framework for the auditors to respond.
Figure 7-1 plots the arithmetic means of the auditors’ responses on the
proposed audit model. The arithmetic mean was 72 for accounting policies,
83 for internal control environment, 61 for entrepreneurial activity, and 75 for
government mechanisms. The pattern is interesting because none of the
values are within the center of the circle, “the bulls-eye.” However, the pattern
clearly shows the auditors surrounded the “bulls-eye.”
The auditors thought that the most important internal forces affecting a
large local government’s financial audit are internal control environment and
government mechanisms. The less important audit force is entrepreneurial
activities. It is interesting to note the auditors’ approach pattern and compare
it to the users approach expectation pattern, for the same scenario, in
Chapter 8.
Question 19 of the auditors’ survey instrument inquired as to how
experienced auditors approach a grant specific audit. A grant specific audit
was defined as a recurring audit with only one Federal program and no
requirement for an audit of the entire government organization.
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Figure 7-1
Proposed Government Audit Model
Big County or City
Internal
Control
Environment
Accounting
Policies
20
40
40
Degrees
Of Risk
(DOR)
20% 60% Low Moderate High
m
40
Entrepreneurial
Activity
Government
Mechanisms
Legend:
____________________Auditors’ responses % = Value of Responses
DOR = Risk to Auditor
(Original figure)
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Figure 7-2 plots the arithmetic means of the auditors’ responses on the
proposed audit model. The arithmetic means were 64 for accounting policies,
77 for internal control environment, 53 for entrepreneurial activity, and 79 for
government mechanisms. The pattern is interesting because none of the
values were again within the center circle, “the bulls-eye.” However, the
pattern clearly shows that government mechanisms and internal control
environment are the two most important internal forces affecting this audit
scenario. It makes sense that entrepreneurial activities would have a low
value because there is generally no risky, complex, or unknown transactions
involved with grants. Also, accounting policies had a low value because most
grant agreements specify the accounting policies to follow. Government
organizations follow the specified accounting policies because, if they did not,
they simply would not be paid.
Question 20 of the auditors’ survey instrument inquired as to how
experienced auditors approach an entrepreneurial organization’s audit.
Special financing authorities were given as examples for entrepreneurial
governments. In California, special financing authorities are involved with
complex, risky transactions because they issue either certificates of
participation notes or revenue notes to build public facilities. The primary
government leases the facility from the authority with the expectation (risk) that
the facility will generate revenues to cover its lease payments, which
approximate the authority’s note payments.
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Figure 7-2
Proposed Government Audit Model
Grant Specific Organization/Program
Internal
Control
Environment
Accounting
Policies
20
40
40
8 0 '
Degrees
Of Risk
(DOR)
20% 60% High Moderate Low
80
40
Entrepreneurial
Activity
Government
Mechanisms
Legend:
____________________ Auditors’ responses % = Value of Responses
DOR = Risk to Auditor
(Original figure)
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Figure 7-3 plots the arithmetic means of the auditors’ responses on the
proposed audit model. The arithmetic means were 74 for accounting policies,
66 for internal control environment, 73 for entrepreneurial activity, and 61 for
government mechanisms. The pattern is interesting because none of the
values were again within the center circle, “the bulls-eye.” However, the
pattern shows that accounting policies and entrepreneurial activities are the
two most important internal forces affecting this audit scenario. It is important
to note that auditors spend a substantial amount of their resources
understanding the entrepreneurial organization and the risky activities in which
it is involved. It is also important that the audit makes sure accounting policies
are appropriately selected to effectively account for and monitor complex, risky
transactions associated with this scenario. The internal control structure and
government mechanisms are valued low because entrepreneurial
governments are generally transaction(s) driven organizations.
7.5 CONCLUSION AND TRANSITION TO CHAPTER 8
This Chapter summarized the auditor group responses to survey
instruments. The survey instruments were designed to test propositions about
the proposed model. Although the propositions are discussed in Chapter 6,
the surveys confirmed the propositions establishing accounting policies,
internal control structure, government mechanisms, and entrepreneurial
activities as important internal forces affecting government financial audits.
The propositions further establish that the existing state and local government
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audit model does not effectively address entrepreneurial activities that are now
commonplace.
The results of the auditors’ survey instruments support all of Chapter
6’s seven propositions. Proposition 5 was least supported by auditors; it
focuses on entrepreneurial activities as an important internal force affecting
government financial audits. However, since the chi-square test that was used
included responses from users, entrepreneurial activities do qualify as an
important internal force affecting audits. This combined analysis highlights an
expectation gap between the auditors and users of government financial
audits regarding auditing entrepreneurial activities. Those auditors who said
that entrepreneurial activities were important provided examples of activities
and how to audit them. These examples are summarized and listed at Tables
7-5 and 7-6, respectively.
The survey responses were useful in applying the proposed model
among different governmental audit scenarios. The three audit scenarios
included in the survey instruments were a large government organization, a
grant specific audit, and an entrepreneurial government organization. The
auditors’ responses, for each important internal force, were calculated into
arithmetic means and plotted on the proposed model. Chapter 9 compares
the auditors’ plotted patterns for each scenario with the users’ patterns for
further analysis.
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Figure 7-3
Proposed Government Audit Model
Entrepreneurial Government
Internal
Control
Environment
Accounting
Policies
20 20
40
40
i O '
Degrees
Of Risk
(DOR)
Low Moderate 60% H igh
80
.40
Entrepreneurial Government
Mechanisms Activity
40
Legend:
(Original figure)
Auditors’ responses % = Value of Responses
DOR = Risk to Auditor
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Chapter 8 similarly summarizes and analyzes the user group’s
responses to the survey instrument. For presentation purposes, Table 7-3
already summarized the results of the chi-square tests for the users. These
results and other questions that were specific to the users’ group are further
analyzed and discussed in Chapter 8.
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CHAPTER 8
ANALYSIS OF RESPONSES TO SURVEY
FROM USERS OF GOVERNMENT FINANCIAL STATEMENTS
8.1 INTRODUCTION
This chapter summarizes and analyzes the user survey instruments.
As discussed in Chapters 6 and 7, the main focus of this study is to determine
how to incorporate entrepreneurial transactions into the government audit
model. This study’s proposed model incorporated four important internal
forces affecting government financial audits. The four forces are accounting
policies, internal control environment, government mechanisms, and
entrepreneurial activities. As with the auditors’ surveys in Chapter 7, the user
survey instruments were designed to assess the proposed model.
8.2 RESPONSE RATES
Table 7-1 shows that 60 surveys were sent to experienced auditors and
users of government financial audits. Since this is a preliminary study, the
sampling approach was to narrow the universe to experienced auditors and
users of government financial audits. Therefore, the users were selected from
the largest counties and cities in California. The sampling approach was to
select, as evenly as possible, among counties and cities starting with entities
that have assets in excess of $1 billion and operating budgets in excess of
$500 million. Then, the sample reached into the next level of entities which
have assets in excess of $500 million and operating budgets in excess of $250
million.
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During the process of selecting a sample from this narrower universe,
the question of what is a user arose. There are many users of government
financial audits. Predominant users are government administrators, elected
officials, funding sources, underwriters, and constituents. This study focused
on experienced users directly responsible for the contracting and overseeing
of audits. This definition included government financial administrators and
elected officials. From these narrow parameters, a sample was selected.
Table 7-1 shows a users’ response rate of 68% and an overall response rate
of 72%.
8.3 SURVEY QUESTIONNAIRE
Table 7-1 shows a user sample size of 41 from which 28 surveys were
returned, representing a 68% response rate from the users group. The users’
survey instrument had 18 questions. The first four questions on the users’
survey, Appendix B, asked for demographic information. Table 8-1
summarizes the users’ group demographic information. It is important to note
that these users are very experienced at managing, reviewing, and utilizing
government financial auditors.
The users’ group overall arithmetic mean years of experience is 16.
For greater depth of analysis, the arithmetic mean years was further broken
down between administrators and elected officials. The user group was
divided between administrators and elected officials to better analyze
expectation gaps between the auditors and users of government financial
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audits. Expectation gaps are even wider between auditors and elected
officials.
Question 10 asked whether users believe government financial auditors
should audit entrepreneurial activities. Out of 28 respondents, 26 or 93%, of
this very experienced user group believed that auditors should audit
entrepreneurial activities.
As presented in Table 7-3, the Likert Scale analysis supports
propositions 2-5 that accounting policies, internal control environment,
government mechanisms, and entrepreneurial activities are important internal
forces. The users’ survey questions 5, 6, 7, and 12 addressed these
propositions. The user groups’ total values were substantially higher than the
auditors’ values, particularly when elected officials are compared with auditors.
Table 7-4 supported Proposition 7’s contention of an expectation gap between
auditors and users. The primary difference is users of government financial
statements firmly believe that auditors should audit entrepreneurial activities.
In contrast, auditors do not believe it is an important internal force. This study
recommends in Chapter 9 that auditors need to meet the needs and
expectations of users.
Question 8 asked respondents to list areas where auditors spend a
substantial part of their audit effort. Table 8-2 lists areas based upon users'
experiences and observations. All but the last item listed fit into one of the
four important internal forces and would be addressed using the proposed
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audit model. The last item listed is not a financial audit, but a performance
audit as defined by the General Accounting Office (Bowsher, 1994).
Question 13 solicited input from users on the kinds of entrepreneurial
activities that are happening in their government organization. Table 8-3 lists
their responses. The responses can be further categorized into four groups.
The groups are financing, multi-agency transactions, grant programs, and
enterprise organizations. This list of entrepreneurial activities is not all-
inclusive, but it does represent typical activities in most agencies. The list
simply can be endless. Chapter 1 attempted to provide some guidance in
identifying entrepreneurial activities. That chapter defined entrepreneurial
activities as, “the risky use of public resources in the creation of value for the
people.”
This study has provided other examples of entrepreneurial activities.
Those additional examples have included risky investment practices,
involvement with sports activities, performance budgeting, measurement, and
compensation systems. In addition, Osborne and Gaebler (1993) provided
several examples of entrepreneurial activities, including privatization, which
are commonly used. Privatization occurs when a private company provides
government services. An important entrepreneurial risk to privatization
transactions is the loss of control over operational issues.
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Table 8-1
Improving Government Audit Model
Respondents’ (Users’) Background Information
Survey Years of
No. Position Experience Degree
1 Technical Manager 13 BS, CPA
21 Audit Analyst 15 BA, GRAD
23 Director Administrative Services 26 BA
24 Vice Mayor * 6 BS, GRAD
25 Finance Director 21 BS
26 Mayor * 2 None
28 Director Administrative Services 30 BS
29 Council Member * 8 BA
30 Finance Director 22 BS
31 Finance Director 25 BA
33 Council Member * 12 None
34 Director Administrative Services 12 BS, GRAD
35 Vice Mayor * 13 BS
36 Finance Director 20 BS, GRAD
37 Administrator 30 BS
38 Finance Director 15 None
40 Council Member * 1 BA, GRAD
41 Deputy Director 23 BA
43 Chief Deputy Director 23 BA, GRAD
44 County Supervisor * 9 BA
45 Controller * 25 BS, GRAD
47 Controller * 28 BS
49 Assistant Controller 25 BS
50 County Supervisor * 5 BS, GRAD
53 Controller * 8 BA
54 County Supervisor * 3 BS
55 Principal Auditor 25 BS
57 Controller * 1 BA, GRAD
Overall Mean 16
Government Administrators Mean 22
Elected Officials Mean 9
* Elected Official
BA Bachelor of Arts
BS Bachelor of Science
GRAD Master’s degree or higher
CPA Certified Public Accountant
(Original table)
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Table 8-2
Improving Government Audit Model
Respondents’ (Users’) Experiences and Observations With
Government Financial Auditors
Survey Question No. 8: Auditors spend a significant part of their effort in the
following other area(s):
■
Items that would be qualitatively material, such as high-risk activities or
activities that would generate a lot of public interest.
■
Electronic Data Processing (EDP) Systems
■
Testing reliability of our Comprehensive Annual Financial Report. We
use our auditors for some internal problems where we lack staffing to
accomplish.
■
Interaction between governmental funds
■
Understanding local systems and procedures
■
Understanding local issues
■
Verifying the balance sheet accounts
■
Year-end balances, balance sheet and changes in these balances.
■
Test income and expenditures making sure posted to correct accounts.
■
The revenue cycle
■
Economic analysis to maximize revenue from leases
■
Procurement and contracting issues
■
Accuracy of figures presented
■
Gathering information during the course of the audit in order to prepare
a management letter with accompanying comments and
recommendations
■
Federal grants/Single Audit reguirements
■
Investment policy
■
Management and program performance
(Original table)
This study has established that users of government financial
statements expect auditors to understand, audit, and report on entrepreneurial
transactions. As is now obvious, governments engage in numerous types of
entrepreneurial activities. Auditors need to address such transactions in their
audit approach.
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Table 8-3
Improving Government Audit Model
Respondents’ (Users’) Government Organization’s
Entrepreneurial Activities
Survey Question No. 13: If applicable, please list the entrepreneurial
activities that your government organization is involved in.__________
■ Separate financing bodies_______________________________________
■ Multi-agency partnerships_______________________________________
■ Joint Powers Agreement (JPA) with staff as governing board_________
■ Grants_______________________________________________________
■ JPA for joint facilities building____________________________________
■ Modesto Irrigation District (MID) surface water project_______________
■ Potential loan pool for new business______________________________
■ Loan pools with Community Development Block Grant (CDBG) funds
■ CDBG activities________________________________________________
■ Certificate of Participation (COPS) for water and sewer enterprises
■ Providing data processing (parking citations) services to other cities
■ Providing grant (Job Training Partnership Act [JTPA]/Service Delivery
Area fSDAD services to other cities_______________________________
■ Water rights lease/lease back___________________________________
■ New wastewater treatment plant through the Needles Financing
Authority & City of Needles & United States Department of Agriculture
(USDA)_______________________________________________________
■ Landfill operation and management______________________________
■ Court facilities financing_________________________________________
■ Certificate of Participation (two responses)_________________________
■ Hospital______________________________________________________
■ Airport (two responses)_________________________________________
■ Public Financing Authority_______________________________________
■ Redevelopment Agency________________________________________
■ JPA-Financing Authority________________________________________
(Original table)
Table 8-4 summarizes responses given to questions 9, 11, 14, and 15.
These questions relate to technical aspects of the audit. The auditors’ group
was better equipped to provide responses than the users’ group. As a result,
several respondents did not answer. However, most of the information is still
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useful because of its consistency with responses given by the more technically
experienced auditors.
Seventy-one percent of users believe that auditors are properly
adjusting their audit focus among the important internal audit forces. Sixty-
eight percent either do not know or do not believe that auditors are effectively
auditing entrepreneurial activities. As for questions 14 and 15, 50% and 71%,
respectively, of the respondents do not know whether auditors should change
their audit model for GASB Statement No. 34 and entrepreneurial activities.
8.4 APPLICATION OF PROPOSED AUDIT MODEL
One of the objectives of this study is to prescribe how to apply the
proposed model. Since the survey sample focused on experienced
professionals, questions were designed to seek input on how to apply the
proposed model with different scenarios. As described in Chapter 7, scenario
details were given and respondents assessed the significance of each force.
The levels were valued between 20 and 100 and an arithmetic mean was
calculated for each force. The results were then plotted on the proposed
model.
The three user scenarios are the same as the auditors’ scenarios.
Those scenarios include a large local government organization, a program
specific audit, and an entrepreneurial government. The question asked for
each scenario was how important are these forces — accounting policies,
internal control environment, entrepreneurial activities, and government
mechanisms - given the scenario.
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Table 8-4
Improving Government Audit Model
Respondents’ (Users’) Survey Results
9. Do auditors appropriately adjust their focus among accounting policies,
internal accounting control environment, government mechanisms, and
other areas (forces) depending on the nature of their audit?
11. Do you believe state and local government financial auditors are
effectively auditing and reporting on entrepreneurial activities?
14. Do you think GASB Statement No. 34, Basic Financial Statements and
Management Discussion and Analysis for State and Local
Governments, necessitates a change in the auditors’ existing auditing
model?
15. Do you think entrepreneurial activities can be covered with the audit
changes for GASB Statement No. 34?
Survey
No.
Audit
Focus
Adjust
Existing model
addresses
entrepreneurial
activity
Existing model
should change
for GASB 34
Include
entrepreneurial
changes with
GASB 34
1 Yes Don’t know Yes Yes
21 Don’t know Don’t know No Yes
23 No No Yes Don’t know
24 Yes No Don’t know Don’t know
25 Yes Yes Yes Don’t know
26 Yes Don’t know Don’t know Don’t know
28 Yes Yes Yes Don’t know
29 Don’t know Don’t know Don’t know Don’t know
30 Yes Yes No No
31 Yes Don’t know Don’t know Don’t know
33 Don’t know No Don’t know Don’t know
34 Yes Don’t know Don’t know Don’t know
35 Don’t know Don’t know Don’t know Don’t know
36 Don’t know Don’t know No Yes
37 Yes Don’t know Yes Don’t know
38 Yes Yes Yes Yes
40 Don’t know Don’t know Don’t know Don’t know
41 Yes No No Don’t know
43 Yes Yes Yes Don’t know
44 Yes Yes Don’t know Don’t know
45 Yes No Don’t know Don’t know
47 Yes No Yes No
49 Yes Don’t know Yes Yes
50 Don’t know Yes Don’t know Don’t know
53 Yes Yes Don’t know Yes
54 Yes Don’t know Don’t know Don’t know
55 Yes No Don’t know Don’t know
57 Yes Yes Yes Don’t know
Summary
Yes 71% 32% 36% 22%
No 4% 35% 14% 7%
Don’t know
or left blank
25% 43% 50% 71%
(Original table)
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The figures display the four forces with applicable values, the least
important value being 20 and the most important value being 100. As
explained in Chapter 7, important is defined as a value of 60 or greater. The
figures also display degrees of risk as being low, moderate, or high. The
degrees of risk relate to the auditor’s degree of risk. If a force is valued high,
the auditor would want to spend resources to reduce the degree of risk to low
so she or he can opine on the area. Assessed levels of auditor’s risk are
further explained in Chapter 5, Section 5.6.
Figure 8-1 shows the users’ expected audit pattern for a large California
county or city. The important internal forces were valued as follows for this
scenario:
Accounting Policies 77
Internal Control Environment 81
Entrepreneurial Activities 63
Government Mechanisms 73
Similar to the auditors’ responses, the most important internal audit force is the
internal control environment. The users expect that auditors, under this
scenario, should spend a substantial amount of their time understanding and
testing accounting and administrative systems. Entrepreneurial activities,
although important, are the least important internal force. Perhaps, the users
believe a strong internal control environment will reduce the risks associated
with entrepreneurial activities.
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Figure 8-1
Proposed Government Audit Model
Big County or City
Internal
Control
Environment
Accounting
Policies
20 20
40
40
80
Degrees
Of Risk
(DOR)
60% 20% High Low Moderate
m
40
40
Entrepreneurial
Activity
Government
Mechanisms
Legend:
(Original figure)
Users’ responses % = Value of Responses
DOR = Risk to Auditor
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Figure 8-2 displays the users’ expected audit pattern of a program
specific organization/program. OMB Circular A-133 (1997), Section 200
defines a program specific audit as auditing only one Federal program with no
requirement to audit the entire agency. The important internal forces were
valued as follows for this scenario.
Accounting Policies 69
Internal Control Environment 72
Entrepreneurial Activities 58
Government Mechanisms 67
The users believed that entrepreneurial activities, for this scenario, should not
be an important internal force. Therefore, to meet user expectations, the
auditors may want to consider spending their time on program specific audits
in accounting policies, internal control environment, and government
mechanisms. Their approach should include audit procedures that would
reduce audit risk in these areas to support their opinion.
Figure 8-3 illustrates the users’ expected audit pattern for an
entrepreneurial government. Question 18 provided special financing
authorities as examples of entrepreneurial governments. The important
internal forces were valued as follows for this scenario:
Accounting Policies 66
Internal Control Environment 69
Entrepreneurial Activities 67
Government Mechanisms 66
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Figure 8-2
Proposed Government Audit Model
Grant Specific Organization/Program
Internal
Control
Environment
Accounting
Policies
20
40
40
80
Degrees
Of Risk
(DOR)
High 60% Moderate Low 20%
80
40
40
Entrepreneurial
Activity
Government
Mechanisms
Legend:
_____________________ Users’ responses % = Value of Responses
DOR = Risk to Auditor
(Original figure)
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All four forces were determined to be important, with internal control
environment and entrepreneurial activities being valued as the most important
internal force. To meet client expectations, auditors should design audit
procedures to document their understanding of entrepreneurial transactions
and how they tested transactional compliance with internal control systems.
8.5 CONCLUSION AND TRANSITION TO CHAPTER 9
This chapter summarized the user group’s responses to survey
instruments. The survey instruments were designed to assess propositions
about the proposed model.
The results of the users’ survey supported all of Chapter 6’s seven
propositions. Table 7-3 (chi-square analysis) shows a combined analysis
supporting the propositions that establish accounting policies, internal control
environment, government mechanisms, and entrepreneurial activities as
important internal forces affecting government financial audits. Table 7-4 (Chi-
square analysis) also shows an expectation gap between auditors and users.
Primarily, the expectation gap is that the users believe that auditors should
spend time understanding and auditing entrepreneurial activities when
appropriate.
This gap means that auditors should reconsider their audit approach
when they are auditing organizations with material entrepreneurial activities.
Obviously, if an entrepreneurial activity does not meet expectations, then the
auditor may be at risk by not auditing and reporting it.
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Figure 8-3
Proposed Government Audit Model
Entrepreneurial Government
Internal
Control
Environment
Accounting
Policies
20 20
40
80
80'
Degrees
Of Risk
(DOR)
Moderate Low High 90% 20% 60%
m
Government
Mechanisms
Entrepreneurial
Activity
.40
40
Legend:
(Original figure)
Users’ responses % = Value of Responses
DOR = Risk to Auditor
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A recent example of this auditor risk is the Orange County Bankruptcy
case. The auditor was held partially responsible for that government’s
entrepreneurial investment transactions (Harrell, 1998).
Table 8-3 and the related discussion provide useful examples of
entrepreneurial activities. Common examples include financing organizations,
multi-agency transactions, grant programs, and enterprise organizations. This
study has also discussed investment transactions, performance budgeting,
measurement, compensation systems, and sports facility transactions. Other
common entrepreneurial transactions cited by Osborne and Gaebler (1993)
are privatization projects.
The survey responses were useful in applying the proposed model to
different governmental audit scenarios. The three audit scenarios provided in
the survey instruments include a large government organization, a grant
specific audit, and an entrepreneurial government organization. The users’
responses for each important internal force were calculated into arithmetic
means and plotted on the proposed model. Chapter 9 compares the users’
plotted patterns for each scenario with the auditors’ patterns for further
analysis.
Chapter 9 is the concluding chapter to this study and discusses
conclusions, implications, and offers suggestions for future research.
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CHAPTER 9
CONCLUSIONS, IMPLICATIONS, AND SUGGESTIONS
FOR FUTURE STUDIES
9.1 STUDY’S OBJECTIVES AND CONCLUSIONS
9.1.1 Background
Government financial auditing is becoming riskier because large state
and local agencies are becoming more complex. Professionals involved with
the audit process are not always sure what should be emphasized in
government financial audits. Within the last decade, there have been several
bodies of authorities providing guidance to financial auditors on how to deal
with the rapidly changing government industry environment. The
Governmental Accounting Standards Board (GASB), the American Institute of
Certified Public Accountants (AICPA), the General Accounting Office (GAO),
and the Office of Management and Budget (OMB) have issued several
standards and guides on how to audit and report on the rapidly changing
government environment.
This study has faulted the existing governmental audit model for failing
to deal adequately with the changing government industry environment. Many
forces are causing governments to change their operational procedures in
providing services. Osborne and Gaebler (1992) have observed this dynamic
in discussing reinventing government. In their book, Reinventing Government,
they observe and prescribe that governments need to be more
entrepreneurial. This study provided several examples of entrepreneurial
activities in government including: risky investment transactions,
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financing authorities, performance budgeting, measurement, compensation
systems, multi-agency transactions, certain grant programs, enterprise
organizations, and privatizing government services. There are many more
entrepreneurial activities in which government organizations can be involved.
To meet today’s needs, governments are using entrepreneurial activities more
than ever. These activities are inherently more risky than traditional
government activities.
9.2 STATEMENT OF THE RESEARCH QUESTION
How can independent financial auditors incorporate
entrepreneurial risk in the state and local government financial audit
model?
To begin this endeavor, the study first develops a working definition for
public entrepreneurship - the risky use of public resources in the creation of
value for the people. The study then discusses and analyzes examples of
entrepreneurial activities and their risks. The researcher then undertakes the
task of understanding and analyzing the existing audit model as issued by the
AICPA. The AICPA (1998) Audit Guide, Audits of State and Local
Governmental Units (ASLGU) has evolved over the years. The guide is
updated periodically by members of the AlCPA’s State and Local Government
Committee. Significant areas in the guide are accounting standards, internal
control environment, and compliance with laws, regulations, and ordinances.
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9.2.1 Theory Development
This study identified accounting policies, internal control environment,
government mechanisms, and entrepreneurial activities as important internal
forces affecting government financial audits and grounded these forces into a
network of administrative theories.
Important Internal Force Administrative Theory
Accounting Policies Agency Theory
Internal Control Environment Risk Theory
Government Mechanisms Institutional Theory
Entrepreneurial Activities Entrepreneurship Theory
Based upon this theoretical framework, a proposed model is developed. Since
this is a preliminary study, the proposed model embodies seven propositions.
The propositions are empirically assessed using survey instruments sent to
experienced auditors and users of government financial statements. Several
statistical tools are used including univariate analyses, chi-square analyses,
and graphs and charts. The analyses supported all seven of the following
propositions:
9.2.2 Propositions
Proposition 1 - The AICPA Audit and Accounting Guide for State and Local
Governmental Units is the most important audit model.
Several different audit guides and standards are used to perform
government financial audits. This study determined which government audit
guide (model) is most often followed when performing state and local
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government financial audits. The AICPA (1998) Audit and Accounting Guide
for State and Local Governmental Units is regarded as the model for financial
audits.
Proposition 2 - Accounting policies are important internal forces affecting the
auditor’ s approach.
The GASB has issued 36 accounting statements. Many of these GASB
statements have significant effects on the way transactions are recorded and
accounting systems are designed. Oftentimes, government organizations
establish accounting systems to capture data that is required by a GASB
statement. Auditors often review and rely upon these accounting systems. An
organization’s accounting policies are an important internal force affecting
governmental financial audits.
Proposition 3 —An organization’ s internal control environment is an important
internal force affecting the auditor’ s approach.
An organization’s internal control environment includes both accounting
and administrative controls. Accounting controls are established procedures
to control financial transactions of organizations. Administrative controls are
established procedures to control administrative transactions of organizations.
Statements on Auditing Standards Nos. 55 and 74 (SOP 98-3, pp. 7-8) require
auditors to review the internal control environment. Auditors often rely on the
internal control environment for government financial audits. As a result, an
organization’s internal control environment is an important internal force
affecting governmental financial audits.
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Proposition 4 —A government organization’s compliance with laws,
ordinances, and regulations is an important internal force affecting the
auditor’s approach.
Administrative systems are established to ensure compliance with laws,
ordinances, and regulations (government mechanisms). Government
Accounting Standards (Bowsher, 1994) and the Single Audit Act 1984 (SOP
98-3) require auditors to understand and test compliance with government
mechanisms. If organizations are not in material compliance with government
mechanisms, the auditor’s opinion on the financial statements is modified
(SOP 98-3, p. 10). The organization’s compliance with laws, ordinances, and
regulations (government mechanisms) is an important internal force affecting
government financial audits.
Proposition 5 - Entrepreneurial activities are an important internal force
affecting the auditor’s approach.
Entrepreneurial transactions are often important, complex, and involve
several government organizations. If transactions do not meet expectations,
government resources are at risk. In the case of Orange County (Orange
County, 1998), the organization filed for bankruptcy after losing approximately
$1.7 billion in investments. Auditors should understand and report these
complex, risky transactions. Entrepreneurial activities are an important
internal force affecting government financial audits.
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Proposition 6 - The AICPA Audit and Accounting Guide for State and Local
Governmental Units does not effectively address how to audit entrepreneurial
activities.
The 1980s and 1990s were labeled the decade of the public
entrepreneur (Bellone and Goerhl, 1992, p. 130). Several government
organizations changed their operations to be more businesslike. Many of the
concepts observed and suggested by Osborne and Gaebler (1993) about
reinventing government have been incorporated into operations. These
concepts are entrepreneurial in nature and inherently more risky. The AICPA
Audit and Accounting Guide for State and Local Governmental Units does not
effectively address entrepreneurial transactions. Since most large local
municipalities are involved with material entrepreneurial transactions, auditors
should consider this area as an important internal force affecting government
financial audits.
Proposition 7 - Users of government financial audits expect auditors are
effectively auditing complex, risky entrepreneurial transactions.
An “expectation gap” exists between users of government financial
audits and auditors. The users believe that auditors appropriately understand,
effectively audit, and properly report material entrepreneurial transactions.
ASLGU does not discuss entrepreneurial transactions. Users of governmental
financial audits expect complex, risky entrepreneurial transactions are being
audited.
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9.3 IMPLICATIONS OF STUDY
9.3.1 Theoretical Framework
Generally accepted governmental auditing standards have been based
on common practice procedures. A theoretical framework has been
developed as a result of this study. To provide greater depth and
understanding, the professional discipline of government auditing needs to
study its practices using theories as lens for examining those practices.
The economic concepts of agency theory are particularly helpful in the
areas of accounting policies and entrepreneurial activities. Monitoring the
relationships between the principal and agent can provide insightful results for
the government auditing discipline. Risk theory can enhance auditor
understanding of the areas of internal control structure and entrepreneurial
activities. The study of various degrees of risk may provide further guidance
on the subjective area of the auditor’s materiality levels. The study of
institutional theory provides auditors with a better understanding of
government organizations, particularly, in the areas of societal values and
political leadership. Societal values eventually become imbedded into
governments’ laws and regulations (government mechanisms). Charismatic,
political leadership is a strong influence in changing government institutions.
Finally, research on public entrepreneurship may help auditors to define
boundaries that administrators and elected officials cannot cross.
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9.3.2 Audit Procedures for Entrepreneurial Risks
Incorporating entrepreneurial risk into a theoretical governmental audit
model is the focus of this study. However, development of audit procedures
does have practical implications. The auditors’ survey group began
addressing this task by providing typical audit procedures they perform on
entrepreneurial transactions. Table 7-5 lists auditing procedures for
entrepreneurial transactions. This study has further suggested using the audit
model recently developed for fraud risks. That model is known as the
Statement on Auditing Standards (SAS) 82 — Consideration of Fraud in a
Financial Statement Audit (Mancino, 1997). The SAS 82 model can be
changed as follows to fit entrepreneurial risks; auditors’ procedures can be
considered for use in this model:
• Assess the risk of material misstatements in the financial statement
caused by entrepreneurial activities.
• Respond to the entrepreneurial risks.
• Evaluate tests designed to reduce material entrepreneurial risks.
• Communicate entrepreneurial activities.
• Document work performed on entrepreneurial risks.
Guidance for auditors could be developed in the following ways: describe
characteristics of entrepreneurial activities and identify risk factors to assess
risk; explain common procedures on how to respond, such as assignment of
personnel, testing of contract agreements, performance testing, etc.;
recommend how to evaluate auditor’s tests and procedures; advise on how to
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appropriately communicate and report entrepreneurial activities, (although the
new reporting model--GASB No. 34--may be used); finally, provide guidance
on how to document important entrepreneurial auditing procedures. Appendix
C provides suggested audit procedures for four common entrepreneurial
activities.
9.3.3 Application of Proposed Model
The important internal forces - accounting policies, internal control
environment, government mechanisms, and entrepreneurial activities — were
tested by empirical work. A theoretical framework supports the proposed
government audit model.
Chapter 5 illustrated how the proposed model may be applied for
different audit scenarios. The three scenarios are a large local government
organization, a grant specific program/organization, and an entrepreneurial
government. The three figures presented in that chapter show distinct
differences between each scenario. To determine whether applications of the
proposed model were accurate, those same scenarios were described in the
survey questions given to experienced auditor and user groups. The results of
the auditors and users groups’ responses are presented in chapters 7 and 8,
respectively. The combined presentations of the study’s projections, the
auditors’ responses, and the users’ responses are presented below.
As chapters 7 and 8 explained, the model incorporates four important
internal forces, measures these forces from 20 to 100, and illustrates the
auditor’s degrees of risk. Forces are determined to be important if they
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are valued at 60 or more. Therefore, depending on how a force is valued, the
auditor usually performs audit procedures to reduce degrees of risk from high
to low.
Figure 9-1 shows the combined presentations for a large local
government.
The survey instruments describe as Scenario 1 (Figure 9-1) - A
recurring large city or county financial audit that has the usual general
government services and enterprise funds, receives federal funds that qualify
for a Single Audit, and has at least one major entrepreneurial transaction.
The study projected this scenario to be extremely important for all four
internal forces and valued each of them at 90. The connected pattern for the
study’s projections shows a box within the inner circle (a bulls-eye). This
pattern would mean all four forces are important and should be audited. The
auditor should spend substantial resources reducing audit risks to low, if
possible. This means audit procedures should be performed on material
areas for each force. The suggested details of those procedures are left to
another study.
The auditors’ and users’ responses show patterns that are similar but
less than the study’s projections. These two groups place the box within the
middle circle. The lines that connect the values between internal control
environment and entrepreneurial activities touch the 90% inner circle.
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Figure 9-1
Proposed Government Audit Model
Big County or City
Internal
Control
Environment
Accounting
Policies
20 20
40
40
Degrees
Of Risk
(DOR)
60% High Low Moderate
m
40
40
Entrepreneurial
Activity
Government
Mechanisms
Legend:
Study’s projections
Auditors’ responses
Users’ responses
% = Value of Responses
DOR = Risk to Auditor
(Original figure)
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This value reflects that auditors are expected to understand and test the
internal control systems and entrepreneurial transactions. A similar line
pattern is shown between internal control environment and accounting
policies. Perhaps auditors should test whether the entrepreneurial
transaction’s accounting policies are being consistently followed.
Figure 9-2 shows the combined presentations for a grant specific
program/organization. The survey questionnaires describe Figure 9-2 as
Scenario 2 - A recurring program specific audit. OMB Circular A-133, Audits
of States. Local Governments, and Non-Profit Organizations. Section 200
(OMB, 1997), defines a program specific audit as auditing only one Federal
program with no requirement for auditing the entire government organization.
For this scenario, the researcher thought accounting policies and
government mechanisms should score 90 and be in the inner circle for these
two forces. The researcher thought that internal control environment and
entrepreneurial activity should not be important forces. These audits are
generally approached by validating grant accounting policies and ensuring
compliance with the grant (Chait, 1995).
The auditors’ and users’ patterns are again similar to the study’s
projected pattern. The auditors’ and users’ patterns demonstrate that the
internal control environment is also important. The patterns for entrepreneurial
activity, for both auditors and users, are not as important. Apparently, the
auditors and users believe that audit resources should be spent testing grant
compliance with accounting policies, government mechanisms, and internal
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control environment. These respondents said that the time spent should be
less than what the study projected.
Figure 9-3 shows the combined presentations for an entrepreneurial
government. The survey questionnaires describe Figure 9-3 as Scenario 3 - a
special financing authority audit. In California, special financing authorities are
involved with complex, risky transactions; they issue either certificates of
participation notes or revenue notes to build public facilities. The primary
government leases the facility from the authority with the expectation (risk) that
the facility will generate revenues to cover its lease payments which
approximate the authority’s note payments.
The researcher projected that accounting policies and entrepreneurial
activity should be rated 90 and internal control environment and government
mechanisms should be rated 40. The researcher thought that auditors should
spend most of their resources understanding and testing entrepreneurial
transactions. In addition, auditors should spend time ensuring that accounting
policies are being consistently followed, including periodic management
reports. The researcher thought that only basic work for government
mechanisms and the internal control environment should be performed.
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Figure 9-2
Proposed Government Audit Model
Grant Specific Organization/Program
Internal
Control
Environment
Accounting
Policies
20
40
Degrees
Of Risk
(DOR)
High Low Moderate i0%
80
40
Entrepreneurial
Activity
Government
Mechanisms
Legend:
Study’s projections
Auditors’ responses
Users’ responses
% = Value of Responses
DOR = Risk to Auditor
(Original figure)
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The auditors and users again have patterns similar to the projected
pattern; however, they both said that all four internal forces are important.
These respondents believe that enough work should be performed in each
area to reduce the auditor’s risk to moderate. The difference between
reducing auditor’s risk from moderate to low could be the number of audit
procedures, types of procedures, etc. This discussion is large enough for
another study.
9.3.4 Applying the Proposed Model to GASB Statement No. 34
GASB Statement No. 34, Basic Financial Statements - and
Management’s Discussion and Analysis — for State and Local Government, is
known as the new reporting model (GASB, 1999). As discussed in Chapter 3,
the new reporting model has significant changes. State and local government
organizations will be required to present management discussion and analysis
(MD&A) information with their financial statements. This requirement is similar
to publicly held corporations’ financial statements. In addition, the new
government-wide financial statements will be prepared on the accrual basis of
accounting for all funds of the government. The financial statements will now
require infrastructure assets to be capitalized and depreciated. The basic
financial statements have been redesigned to emphasize viewing the
government organization from a long-term point of view.
The statement of net assets emphasizes the government’s combined
net asset balances. It is believed that many governments have accumulated
deficit net assets because many obligations are now required to be accrued on
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financial statements. Also, the statement of activities has been designed to
present net expenses and revenues for each major government activity.
This change shows audited net costs on activities that are being
subsidized by the community. Decision-makers can use this information to
better decide whether they want to continue with any activity.
The proposed audit model can be used to audit balances and activities
for the new GASB reporting model. For example, the old financial reporting
model made it difficult to report entrepreneurial activities. If an auditor wanted
to report entrepreneurial activities, she or he would have reported them in the
footnotes. The new reporting model provides three places to report
entrepreneurial activities. The auditor can report them in the cover letter
(required if CAFR is presented), MD&A, or the footnotes. The cover letter is
prepared by management, and the auditor’s assurances are limited to
ensuring information in it is consistent with the financial statements. The new
MD&A provides more information, but still limits auditor’s assurances. The
footnotes would require auditor’s assurances that the information has been
audited.
Therefore, it is highly likely that a new activity, such as an
entrepreneurial activity, could be in the MD&A section of the financial
statements.
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Figure 9-3
Proposed Government Audit Model
Entrepreneurial Government
Internal
Control
Environment
Accounting
Policies
20 20
40
BU
Degrees
Of Risk
(DOR)
20 ° / High 60% Low Moderate
80
m
40
40
Entrepreneurial
Activity
Government
Mechanisms
Legend:
___________________ Study’s projections % = Value of Responses
____________________Auditors’ responses DOR = Risk to Auditor
___________________ Users’ responses
(Original figure)
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GASB Statement No. 34 provides guidance on the kind of information that
should be in the MD&A. Some of that guidance includes significant capital
assets and long-term debt activity and a description of currently known facts,
decisions, or conditions that are expected to have a significant effect on the
financial position or results of operations. In most cases, entrepreneurial
activities meet these criteria and should be annually presented for comparison
and accountability reasons.
9.4 SUGGESTIONS FOR FUTURE STUDIES
Since a proposed model has been presented, there are many
possibilities for future studies. The discipline of governmental financial
auditing would benefit from more research.
One study could simply challenge all the important internal forces with a
more comprehensive empirical study. The study could also challenge many of
the assumptions made in this preliminary study, for example, the valuing of
responses from the survey instruments, use of the chi-square test as opposed
to another analytical tool, and addition of external forces to this internal forces
model. Global economics is an example of an external force that has an
impact on many large state and local governments.
Other studies could deal with the theoretical framework of the proposed
model. Perhaps, additional studies could focus on agency, risk, institutional,
and entrepreneurship theories. The researcher could analyze in more detail
shifts in certain institutions and their effects on increases or decreases in
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government mechanisms. Further research could incorporate areas where
certain kinds of leaders may have impacts.
As mentioned previously in this chapter, application studies are needed.
Researchers could determine what common audit procedures should be
applied for different audit scenarios. This would be greatly appreciated by the
audit community because there is confusion about where to focus an audit and
what procedures to use. Perhaps, future studies will provide greater
understanding in this area.
Finally, not because of lack of study subjects, but because this study is
basically complete, more research can be done with both SAS No. 82 and
GASB No. 34. Research on SAS No. 82 could help develop audit procedures
for entrepreneurial risks. Research on GASB Statement No. 34 could help to
determine how the proposed model may best be applied to the new reporting
model.
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254
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APPENDIX A
Auditors
Survey Questionnaire
State and Local Government Audit Model
Thank you for participating in this dissertation research on state and local
government financial audits. The questionnaire is coded for control purposes.
Your answers will be kept strictly confidential, and only general information
will be provided as part of the results of the survey. I will greatly appreciate
your mailing the completed survey questionnaire, using the enclosed self-
addressed stamped envelope, on or before March 15, 2000. You may also
FAX the completed survey to my office (916) 928-2755.
Instructions: For your responses, circle the number, word, or fill in the blank
space where applicable. Please answer all questions. Thank you again.
1. What is the name of your audit organization?
2. What is your current position?
3. How many years of audit experience do you have?
4. What college degree(s) have you earned?
5. What professional license(s)/designation(s) do you hold (CPA, CGFM,
etc.)?
For the questions 6 to 11, please consider the A.I.C.P.A. Audit and Accounting
Guide for State and Local Governmental Units, along with your audit
experience, in your responses.
255
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6. The Guide is the most important audit model for state and local
government financial audits.
5 4 3 2 1
Strongly Minimally
Agree Agree
7. The government organization’s accounting policies are where you
spend a significant part of your audit effort. [For this study, accounting
policies include the organization’s adopted accounting policies based
upon applicable GASBs. In addition, accounting policies include
auditing year-end balances such as cash, fixed assets, long-term debt,
etc.]
5 4 3 2 1
Strongly Minimally
Agree Agree
8. The government organization’s internal control environment is where
you spend a significant part of your audit effort. [This includes
understanding, relying upon, and testing applicable internal accounting
control systems such as the general ledger system, payroll system,
etc.]
5 4 3 2 1
Strongly Minimally
Agree Agree
9. Auditing the government organization’s compliance with laws,
ordinances, and regulations (Government Mechanisms) is where you
spend a significant part of your effort. [Government Mechanisms
include understanding, relying, and testing internal control systems
established to ensure compliance.]
5 4 3 2 1
Strongly Minimally
Agree Agree
10. You spend a significant part of your audit effort in the following other
area(s).
11. Does your audit focus adjust among accounting policies, internal
accounting control environment, government mechanisms, and other
forces depending on the organization you are auditing?
Yes No Don’t Know
256
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Entrepreneurial Activity - This study has defined entrepreneurial activity as
the risky use o f public resources in the creation o f value for the citizenry.
An example of entrepreneurial activity is risky investment strategies. Another
example is complex, risky transactions involving several government
organizations or private organizations. A final example is establishing a
separate financing district to build government facilities using certificate of
participation notes and expecting the facility’s operations to generate revenues
to pay the notes. The next six questions relate to entrepreneurial activities.
12. Do you believe government financial auditors should audit and report
on entrepreneurial activities?
Yes No Don’t Know
13. Do you believe the A.I.C.P.A. Audit and Accounting Guide for State and
Local Governmental Units effectively addresses entrepreneurial
activities?
Yes No Don’t Know
14. Auditing the government organization’s involvement with
entrepreneurial activities is where you spend a significant part of your
audit effort.
5 4 3 2 1
Strongly Minimally
Agree Agree
15. If applicable, please list typical auditing procedures performed on
entrepreneurial transactions.
16 Do you think GASB Statement No. 34, Basic Financial Statements and
Management Discussion and Analysis for State and Local
Governments, necessitates a change in our existing auditing model?
Yes No Don’t Know
257
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17. Do you think entrepreneurial activities can be covered with the audit
changes for GASB Statement No. 34?
Yes No Don’t Know
Questions 18 through 20 are designed to determine how you are approaching
different types of local, financial government audits. Based on your
experience, please respond to the following three scenarios. Each scenario
addresses accounting policies, internal control environment, government
mechanisms, and entrepreneurial activities previously defined in this survey.
18. Scenario 1 - A recurring large city or county financial audit that has the
usual general government services and enterprise funds, receives
federal funds that qualify for a Single Audit, and has at least one major
entrepreneurial transaction. (Please circle the level of audit effort you
perform for each area.)
Accounting Policies
5 4 3
Significant
Audit Effort
1
Very Little
Audit Effort
Internal Control Environment
5 4 3 2
Significant
Audit Effort
1
Very Little
Audit Effort
Government Mechanisms
5 4 3 2
Significant
Audit Effort
1
Very Little
Audit Effort
Entrepreneurial Activities
5 4 3 2 1
Significant Very Little
Audit Effort Audit Effort
19. Scenario 2 - A recurring program specific audit. OMB Circular A-133,
Audits of States, Local Governments, and Non-Profit Organizations,
Section 200, defines a program specific audit as auditing only one
Federal program; and there is no requirement for an audit of the entire
government organization. (Please circle the level of audit effort you
perform for each area.)
Accounting Policies
5 4 3 2 1
Significant Very Little
Audit Effort Audit Effort
258
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Internal Control Environment
5 4 3 2 1
Significant Very Little
Audit Effort Audit Effort
Government Mechanisms
5 4 3
Significant
Audit Effort
1
Very Little
Audit Effort
Entrepreneurial Activities
5 4 3
Significant
Audit Effort
1
Very Little
Audit Effort
20. Scenario 3 - A special financing authority audit. In California, special
financing authorities are involved with complex risky transactions; they
issue either certificates of participation notes or revenue notes to build
public facilities. The primary government leases the facility from the
authority with the expectation (risk) that the facility will generate
revenues to cover its lease payments, which approximate the
authority’s note payments. (Please circle the level of audit effort you
perform for each area.)
Accounting Policies
5 4 3
Significant
Audit Effort
1
Very Little
Audit Effort
Internal Control Environment
5 4 3 2 1
Significant Very Little
Audit Effort Audit Effort
Government Mechanisms
5 4 3
Significant
Audit Effort
1
Very Little
Audit Effort
Entrepreneurial Activities
5 4 3
Significant
Audit Effort
1
Very Little
Audit Effort
259
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APPENDIX B
Users of Government Audits
Survey Questionnaire
State and Local Government Audit Model
Thank you for participating in this dissertation research on state and local
government financial audits. The questionnaire is coded for control purposes.
Your answers will be kept strictly confidential, and only general information
will be provided as part of the results of the survey. I will greatly appreciate
your mailing the completed survey questionnaire, using the enclosed self-
addressed stamped envelope, on or before March 15, 2000. You may also
FAX the completed survey to my office (916) 928-2755.
Instructions: For your responses, circle the number, word, or fill in the blank
space where applicable. Please answer all questions. Thank you again.
1. What is the name of your organization?
4. What is your current position?
5. How many years of experience do you have?
4. What college degree(s) have you earned?
Reproduced with permission of the copyright owner. Further reproduction prohibited without permission.
The following questions relate to your experiences and observations with state
and local government financial auditors:
5. Auditors spend a significant part of their effort auditing the government
organization’s accounting policies. [For this study, accounting policies
include the organization’s adopted accounting policies based upon
applicable Governmental Accounting Standards Board Statements
(GASBs). In addition, accounting policies include auditing year-end
balances like cash, fixed assets, long-term debt, etc.]
5 4 3 2 1
Strongly Minimally
Agree Agree
12. Auditors spend a significant part of their effort auditing government
organization’s internal control environment. [This includes
understanding, relying upon, and testing applicable internal accounting
control systems such as the general ledger system, payroll system,
etc.]
5 4 3 2 1
Strongly Minimally
Agree Agree
13. Auditors spend a significant part of their effort auditing the government
organization’s compliance with laws, ordinances, and regulations
(Government Mechanisms). [Government Mechanisms include
understanding, relying, and testing internal control systems established
to ensure compliance.]
5 4 3 2 1
Strongly Minimally
Agree Agree
14. Auditors spend a significant part of their effort in the following other
area(s).
15. Auditors appropriately adjust their focus among accounting policies,
internal accounting control environment, government mechanisms, and
other areas (forces) depending on the nature of their audit?
Yes No Don’t Know
261
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Entrepreneurial Activity - This study has defined entrepreneurial activity as
the risky use of public resources in the creation o f value for the citizenry.
An example of entrepreneurial activity is risky investment strategies. Another
example is complex, risky transactions involving several government
organizations or private organizations. A final example is establishing a
separate financing district to build government facilities using certificate of
participation notes and expecting the facility’s operations to generate revenues
to pay the notes. The next several questions relate to entrepreneurial
activities.
10. Do you believe government financial auditors should audit
entrepreneurial activities?
Yes No Don’t Know
11. Do you believe state and local government financial auditors are
effectively auditing and reporting on entrepreneurial activities?
Yes No Don’t Know
16. Entrepreneurial activities should be a significant audit area (force) for
state and local government organizations.
5 4 3 2 1
Strongly Minimally
Agree Agree
17. If applicable, please list the entrepreneurial activities that your
government organization is involved in.
14. Do you think GASB Statement No. 34, Basic Financial Statements and
Management Discussion and Analysis for State and Local
Governments, necessitates a change in the auditors’ existing auditing
model?
Yes No Don’t Know
262
Reproduced with permission of the copyright owner. Further reproduction prohibited without permission.
15. Do you think entrepreneurial activities can be covered with the audit
changes for GASB Statement No. 34?
Yes No Don’t Know
Questions 16 through 18 are designed to determine how auditors are
approaching different types of local, financial government audits. Based on
your observations and experience with auditors, please respond to the
following three scenarios. Each scenario addresses accounting policies,
internal control environment, government mechanisms, and entrepreneurial
activities previously defined in this survey.
16. Scenario 1 - A recurring large city or county financial audit that has the
usual general government services and enterprise funds, receives
federal funds that qualify for a Single Audit, and has at least one major
entrepreneurial transaction. (Please circle the level of audit effort you
have observed for each area.)
Accounting Policies
5 4 3 2 1
Significant Very Little
Audit Effort Audit Effort
Internal Control Environment
5 4 3 2 1
Significant Very Little
Audit Effort Audit Effort
Government Mechanisms
5 4 3 2 1
Significant Very Little
Audit Effort Audit Effort
Entrepreneurial Activities
5 4 3
Significant
Audit Effort
1
Very Little
Audit Effort
17. Scenario 2 - A recurring program specific audit. OMB Circular A-133,
Audits of States, Local Governments, and Non-Profit Organizations,
Section 200, defines a program specific audit as auditing only one
Federal program; and there is no requirement for an audit of the entire
government organization. (Please circle the level of audit effort you
have observed for each area.)
Accounting Policies
5 4 3
Significant
Audit Effort
1
Very Little
Audit Effort
263
Reproduced with permission of the copyright owner. Further reproduction prohibited without permission.
Internal Control Environment
5 4 3 2 1
Significant Very Little
Audit Effort Audit Effort
Government Mechanisms
5 4 3 2 1
Significant Very Little
Audit Effort Audit Effort
Entrepreneurial Activities
5 4 3 2 1
Significant Very Little
Audit Effort Audit Effort
18. Scenario 3 - A special financing authority audit. In California, special
financing authorities are involved with complex risky transactions; they
issue either certificates of participation notes or revenue notes to build
public facilities. The primary government leases the facility from the
authority with the expectation (risk) that the facility will generate
revenues to cover its lease payments, which approximate the
authority’s note payments. (Please circle the level of audit effort you
have observed for each area.)
Accounting Policies
5 4 3 2 1
Significant Very Little
Audit Effort Audit Effort
Internal Control Environment
5 4 3 2 1
Significant Very Little
Audit Effort Audit Effort
Government Mechanisms
5 4 3 2 1
Significant Very Little
Audit Effort Audit Effort
Entrepreneurial Activities
5 4 3 2 1
Significant Very Little
Audit Effort Audit Effort
264
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APPENDIX C
Audit Procedures for Common Entrepreneurial Activities
Entrepreneurial Activities - The risky use of public resources in the creation of
value for the people.
General Procedures:
• Review the government’s minutes, agreements, attorney’s letters,
etc., to determine whether it is involved in any entrepreneurial
transactions.
• Determine whether the entrepreneurial activity is material to the
financial statements.
• Obtain an understanding of the activity from appropriate government
personnel.
• Obtain and review appropriate documents about the entrepreneurial
activity.
• If applicable, annually review and verify the performance of the
entrepreneurial activity against projected performance.
• Consider the possibility of material fraud in accordance with
Statement of Audit Standards (SAS) No. 82.
• Obtain applicable client’s representation about entrepreneurial
transactions, including an assessment of risk, whether the
transaction is meeting performance goals, and whether it is properly
reported in the financial statements.
• Depending on the entrepreneurial activity, consider reporting it in the
cover letter, management discussion and analysis (MD&A), basic
financial statements, or footnotes sections.
Specific Procedures:
Risky Investment Practices:
• Determine whether investment practices are too risky and fall within
the definition of an entrepreneurial activity. For example, investment
practices are earning a higher than normal yield and investment
incomes are expected to balance the budget.
• Obtain and document an understanding of applicable investment
policies of the government.
• Obtain and document an understanding of the applicable internal
control environment...both accounting and administrative controls.
265
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• Determine whether investment policies are in accordance with
applicable laws, regulations, and government codes.
• Select a representative sample of risky investments and verify
whether transactions are in accordance with applicable internal
controls, laws, regulations, and government codes.
• Obtain cash flow analysis and verify that data is accurate and
determine assumptions are conservative and risky investments were
properly considered.
• Obtain the government analyst’s periodic reports on investment
performance and market risks. Determine whether the reports are
accurate and considered major factors of investment risks.
• If reverse repurchase agreements are used, verify whether they are
properly matched when they become due.
• If investments are part of an “external” investment pool, determine
whether percentage of outside investors increases the pool risks.
Special Financing Districts:
• Review applicable governing board minutes of meetings regarding
transactions regarding the Financing District.
• Obtain analyst’s projections on the facility’s construction and
expected revenue/fund sources to pay debt.
• Determine whether assumptions appear reasonable and have been
achieved to date.
• Obtain copies of applicable offering statements.
• Determine whether debt is properly recorded, including the handling
of premiums and discounts.
• Audit and report the capital lease arrangement between the primary
government and the Financing District. Determine that the lease
agreement and its related arrangement are legal and in accordance
with government laws, regulations, and codes.
• Determine whether the financing arrangement is contingent upon a
revenue stream paying the debt.
• If transaction is not meeting expectations, determine how debt
payments are being paid. Also, determine whether there is a need
for additional financial statement disclosure.
• Determine whether applicable debt covenants also have been met.
• Determine whether adequate funds have been reserved for
contingencies.
• Consider how Financing District is reported in the financial
statements and determine whether there is a need for additional
disclosure. Perhaps, certain Financing Districts’ transactions should
be annually reported in the MD&A section of the CAFR.
266
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Performance Measurement Systems:
• Determine whether a performance measurement system has been
implemented.
• Determine whether the system is part of the budget process.
• If the system is part of the budget process, determine whether the
following is being done:
• The governing body has adopted a budget for all funds in
accordance with state statutory or other requirements.
• The budget provides sufficient detail to provide meaningful
comparisons and analyses with actual transactions and results.
• The performance budget and actual results are presented in the
required supplemental information (RSI) section of the financial
statements. Review the reconciliation between the performance
budget and GAAP information and determine that it has been
properly prepared.
• Determine whether all inter-fund transfers are budgeted.
• Determine whether budget amendments are properly authorized.
• Determine whether performance measures are reasonable and
provide insightful information about operations.
• Determine whether performance measures reflect the missions,
goals, and objectives of the organization.
• Determine whether an “incentive” program has been implemented.
• Understand the “incentive” program and related internal control
structure, if applicable and material to the financial statements.
• Perform tests of “incentive” program and related measurement
systems.
Privatizing Services:
• Obtain analysis on goals and objectives for privatizing government
services.
• Read minutes of meetings of the governing board or any other
administrative board with management oversight.
• Obtain the agreement between government and private company.
Understand the types of services that are provided on behalf of the
government by the company and the applicable financial
arrangement between both organizations. Particularly, understand
the ultimate responsibilities and risks for each organization.
• Inquire with government’s legal counsel about legality of the
transaction and determine if ail laws, regulations, and codes are
being met and not being violated.
• Review and audit applicable documents associated with the
privatization agreement, for example, monthly reports and
applicable supporting documents.
• Consider whether confirming certain amounts or data from an
independent third party would be appropriate.
267
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Determine whether it is appropriate to audit the private company’s
operations.
Review analyst’s periodic progress reports on the privatized
services and determine whether goals and objectives are being met.
Determine whether privatized services are properly reported in the
financial statements. Consider providing annual data in MD&A
section of the CAFR.
268
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Asset Metadata

Creator Macias, Kenneth Abel (author)

Core Title A financial audit model for entrepreneurial governments

School School of Policy, Planning and Development

Degree Doctor of Public Administration

Degree Program Public Administration

Publisher University of Southern California (original), University of Southern California. Libraries (digital)

Tag business administration, accounting,OAI-PMH Harvest,Political Science, public administration

Language English

Contributor Digitized by ProQuest (provenance)

Advisor Clayton, Ross (committee chair), Comrie, Keith (committee member), Newland, Chester (committee member)

Permanent Link (DOI) https://doi.org/10.25549/usctheses-c16-82068

Unique identifier UC11326989

Identifier 3018104.pdf (filename),usctheses-c16-82068 (legacy record id)

Legacy Identifier 3018104.pdf

Dmrecord 82068

Document Type Dissertation

Rights Macias, Kenneth Abel

Type texts

Source University of Southern California (contributing entity), University of Southern California Dissertations and Theses (collection)

Access Conditions The author retains rights to his/her dissertation, thesis or other graduate work according to U.S. copyright law. Electronic access is being provided by the USC Libraries in agreement with the au...

Repository Name University of Southern California Digital Library

Repository Location USC Digital Library, University of Southern California, University Park Campus, Los Angeles, California 90089, USA