AN AUDIT MAY NOT BE WHAT YOU THINK IT IS: GOING BEYOND THE OPINION LETTER TO BETTER GOVERNANCE

NAAG-NASCO (for those not in the know—The National Association of Attorneys General and the National Association of State Charity Officials) held their annual public conference on Monday (October 25, 2004) in Washington, D.C. The Conference delivered even more than the program agenda indicated. It was a very worthwhile day.

Julie L. Floch, the Director of Not-for-Profit Services at Eisner LLP, a large New York-New Jersey accounting firm, gave what many agreed was one of the highlight presentations of the day. Her topic: THE CHANGING LANDSCAPE OF NONPROFIT GOVERNANCE AND THE AUDIT PROCESS: WHAT IS THE LINK?

Ms. Floch focused on perceptions, contending that too many...

 

Our Guide, "Avoiding Trouble While Doing Good, A Guide for the Non-Profit Director and Officer," devotes an entire module to financial statements, the audit process, and auditor opinion letters. We also discuss SAS 99. The overall focus of this discussion is on governance. Buy a copy of our Guide today. Call us at 888.824.6706 for additional information. We also do on site training.

non-profit boards, officers, and audit committees over-emphasize the practical importance of the audit opinion. To bring her point home, Ms. Floch posited two non-profit audit clients, presumably of equal size. During the course of Non-Profit A's audit, Ms. Floch's firm might require A to make 50 adjustments to its financial statements. These adjustments could include adjusting accruals, recalculating depreciation, properly recognizing volunteer service, and a myriad of others. The work at Non-Profit B turns out to be much easier, with no adjustments to the financial statements being required. Aside from changing the names, both Non-Profit A and Non-Profit B will receive the same audit opinion, all other things being equal.

Both audit opinions tell the reader about the financial statements as of a given date. They don't say anything about the reliability of budgets prepared by management two months hence or any interim financial statements. However, if both boards knew about the adjustments that were required, we suspect the Non-Profit A's board would look at interim financial statements a little more skeptically than Non-Profit B's board. The implication: The board, management, and the audit committee must be willing to look beyond the audit letter, entering into an ongoing dialogue with the auditor.

Ms. Floch also pointed out some basic facts that boards, management, and the public often get wrong when thinking about the work of independent auditors. The financial statements are prepared by and are the responsibility of management, not the auditors. The audit opinion is not a guarantee. It is simply is the culmination of a testing and review process conducted by the auditor. The auditor comes into the organization, assesses the internal controls using a series of check lists, and then performs a variety of reconciliations and tests to determine that the financial statements are consistent with the underlying accounting records.

Ms. Floch then noted that there are a number of by-products from this process. First, and most importantly, there is a management letter from the auditors to management describing weaknesses in the system of internal controls. These weaknesses may provide an unscrupulous employee, contractor, or vendor the opportunity to perpetrate a fraud against the organization. Or these weaknesses may result in inaccurate interim financial statements. The management letter and management's reaction to it raise the age old question: Does a falling tree make a sound if no one is in the forest? Put more bluntly, both the board and management are acting irresponsibility if they ignore the management letter. According to Ms. Floch, the board and management should focus much more attention on this letter than many do.

Ms. Floch also indicated that the auditors want to meet with the board's audit committee to discuss issues raised in the management letter, as well as other issues. Unfortunately, many audit committees only want a five minute meeting with the auditors, fearing a deluge of numbers. But the auditors, more often than not, want to talk about philosophical and practical issues for better protecting organizational assets and producing more useful and accurate information from the accounting system.

Historically, the terms "financial controls" and "internal controls" have been used interchangeably. Since Enron and other recent corporate scandals, people have begun to draw a distinction between the two terms. This distinction is now reflected in Statement on Auditing Standards 99 which requires auditors to assess the risk of fraud while conducting an audit of financial statements. Auditors will continue to focus on financial controls. These are the checks and balances that are designed to minimize errors and misappropriation of assets. These controls generally separate incompatible functions. For example, the person who reconciles the bank statement should not be the person with check-writing authority. According to Ms. Floch, auditors will continue to "talk accounting" (our phrase, not hers) with the finance people. That's the green-eyeshades discussion. However, SAS 99 mandates that the auditors go beyond financial control, looking at a larger universe of internal controls. This means talking to people in the human resources, fundraising, and service delivery departments, asking them what they do, whether they see opportunities for fraud, and how the formal and informal lines of communication work.

There has been a lot of discussion in legal and non-profit circles about whether SAS 99 is a roadmap for plaintiff's lawyers or whether it will significantly increase auditing fees. Only time will tell. But Ms. Floch has noticed that when an auditor implements the protocols set out in SAS 99, management and non-financial employees become much more sensitive to governance issues. In Ms. Floch's view, this is a very positive development. SAS 99 is asking the auditors to focus on broader range of governance controls such as hiring practices, internal whistleblower lines of communication, and grant compliance procedures, among others. Ms. Floch hopes that by focusing on these broader controls, the auditors can help the board and management see the vital link between these controls and good governance. In short, Ms. Floch's approach to the audit process is very proactive and pro governance.

Ms. Floch then answered a number of questions from the audience. During this part of the discussion, she pointed out that any requirement forcing non-profits to change auditors every five years would be very expensive. She indicated that the first year audit for a new client simply doesn't payoff for her firm because of the depth of the required initial review. It is only through a long-term relationship that her firm can recoup these costs. Obviously, a shorter-term relationship would require the firm to increase fees (our inference not her statement).

Ms. Floch also urged non-profits to review the AICPA peer review studies for accounting firms before entering into an engagement with a accounting firm. These are available at: http://peerreview.aicpaservices.org/publicfile/default.asp

 

THE FOREGOING IS NOT AND SHOULD NOT BE TAKEN AS LEGAL ADVICE. IF LEGAL ADVICE IS REQUIRED, THE NON-PROFIT OR OTHER PARTY IN QUESTION SHOULD SEEK THE ADVICE OF QUALIFIED LEGAL COUNSEL. If you liked this post, please visit http://www.charitygovernance.com for a description of our Guide/Tutorial for non-profit directors and officers entitled “Avoiding Trouble While Doing Good: A Guide for the Non-Profit Director and Officer.” Copyright 2004, Auto Didactix LLC. All Rights Reserved. You may not copy any portion of this post to a computer "clipboard" for reposting anywhere or e-mailing, or otherwise reproduce this post. If you want others to review this post, you may provide them with a link to this web blog. Any use of the material or ideas in this post by reporters or other publishers shall make reference to Jack Siegel, author of "Avoiding Trouble While Doing Good, A Guide for the Non-Profit Director and Officer" and this web blog.