1. Essentials of Accounting for Governmental and Not-for-Profit Organizations Chapter 13 Auditing; Tax-Exempt Organizations; and Performance Evaluation Copyright © 2015 McGraw-Hill Education. All rights reserved.

2. 13-2 Chapter 13 – Learning objectives Describe the unique characteristics of audits of governmental and not-for-profit entities Describe the major requirements of the Single Audit Act Describe the reporting requirements of tax- exempt entities. Identify when a not-for-profit organization is subject to the unrelated business income tax and describe how the tax is determined.

3. 13-3 Chapter 13 – Learning objectives continued Identify financial ratios commonly used to evaluate governments and not-for-profits and describe how they are calculated and interpreted. Identify the elements of service efforts and accomplishments reporting and explain why governments and not-for-profits report nonfinancial performance measures

4. 13-4 Part 1: Governmental Auditing

5. 13-5 Source of Auditing Standards AICPA – Statements of Auditing Standards (GAAS) GAO – Government Auditing Standards (GAGAS) AICPA Audit and Accounting Guides Audits of State and Local Governments Not-for-profit Organizations

6. 13-6 Government Auditing Standards: aka The Yellow Book Government Auditing Standards, issued by the GAO, incorporate AICPA auditing standards and provide extensions that are necessary due to the unique nature of public entities

7. 13-7 Differences in Public Sector Audits Auditors must possess knowledge of government accounting and auditing Public availability of audit reports Written evaluations of internal controls Distribution of audit reports and availability of working papers to federal authorities

8. 13-8 Types of Engagements Financial Audits Provide reasonable assurance that financial statements are presented fairly in all material respects and comply with GAAP. Attestation Engagements Include Reporting on: Internal controls Compliance with laws and regulations Prospective financial information Costs under contracts

9. 13-9 Types of Engagements, cont’d Performance Audits Economy and efficiency audits – involve aspects of appropriate acquisition, use, and safeguarding of resources Program audits – assess the degree to which mission objectives have been achieved while adhering to applicable laws and regulations Nonaudit Services Providing or explaining information Providing advice or assistance to management

10. 13-10 Financial Statement Audits Auditors must first determine a level of materiality for each opinion unit Financial statement audits involve examination of transactions on a test basis, forming judgments about internal controls and compliance with laws and regulations, and rendering an opinion about whether the financial statements are prepared fairly in accordance with GAAP.

11. 13-11 Opinion Units Because of the various levels of reporting (government-wide, fund-type, and individual fund) the auditor must determine a level of materiality for each. A separate materiality evaluation is made for: Governmental activities Business-type activities Each major fund Aggregate component units The aggregate of all remaining fund information

12. 13-12 Opinion units, cont’d One effect of reporting on opinion units is that some opinion units may receive unqualified opinions while others receive modified opinions. For example: failure to report infrastructure assets could result in an adverse opinion regarding the governmental activities (government-wide statements) and an unqualified opinion for all other opinion units.

13. 13-13 The Auditor Is Required to Prepare up to Five Reports 1. A report containing an opinion on the financial statements. 2. A report discussing the evaluation and testing of internal control and compliance with laws and regulations. 3. A report discussing significant deficiencies in internal controls. 4. A report describing instances of fraud, illegal acts, or other material noncompliance. 5. A report containing the views of responsible officials of the audited organization regarding any reported significant deficiencies.

14. 13-14 Types of Audit Opinions on Overall Statements Unmodified – Statements appear to be in conformity with GAAP -- no qualifying language. Qualified – Largely in conformity with GAAP except for some specified item(s). Adverse – Not in accordance with GAAP. Disclaimer – Not able to express an opinion, usually because the auditor was precluded from doing some necessary procedure.

15. 13-15 Purpose of Single Audit Act Before 1984, State and local governments and Not- for-profits receiving financial aid from several different federal agencies, had multiple audits. The initial Single Audit Act sought to impose one set of stringent audit guidelines so that only one audit would have to be conducted to satisfy multiple grantor agencies.

16. 13-16 Single Audit: Development The initial Single Audit Acts in OMB circulars A- 128 and A-133 required a single audit if federal financial assistance was over $100,000. In 1996 Circular A-133 was revised and replaced with Circular A-128. The current threshold for a single audit is federal financial assistance EXPENDITURES of over $500,000. If federal assistance is > $500,000, but is all from one agency, a program audit may be used instead of a single audit.

17. 13-17 Who Receives the Audit Reports? Cognizant agency Entities with $50 Million or more of federal awards are monitored by a cognizant agency – This is usually the agency with largest grants. Otherwise the entity is assigned an Oversight agency Again, this is typically the agency with largest grants

18. 13-18 The Auditor Is to Follow a Risk-Based Audit Process The auditor must identify MAJOR programs The auditor must group programs using a risk-based approach Type A - larger programs Type B - smaller programs and low risk large programs Type A programs receive closer auditing than Type B’s

19. 13-19 Selecting Programs for Audit Generally, the auditor is required to express an opinion on compliance on major programs which must add up to 50% of the federal funds expended by the audited organization However, if the audited organization is determined to be “low risk,” the percentage is lowered to 25%

20. 13-20 Part 2: Taxation & not-for-profit organizations

21. 13-21 Tax-Exempt Organizations Most nonprofits file IRS form 1023 Application for Recognition of Exemption to obtain favorable tax treatment for donors Tax exempt status permits the donors to deduct their contributions to the Not-for-profit organization when determining the donor’s income taxes Local law governs exemptions from sales tax and property tax.

22. 13-22 Tax-Exempt Organizations – Filing Requirements NFPs must file an IRS Form 990 information return NFPs with over $1000 of unrelated business income file Form 990-T. Other reports may be filed with the state.

23. 13-23 Tax Code: Types of Non-Profits The tax code specifies several different classes of nonprofit organizations by purpose. The most common are §501(c)(3) organizations

24. 13-24 §501(c)3 Organizations Include religious, charitable, scientific, literary, educational, amateur sports organizations, orgs for prevent of cruelty to children or animals. Requires that earnings not be distributed to owners and the organization does not engage io substantial political activity. 501(c)(3)’s status allows donors to take a charitable deduction on their U.S. tax return for donations.

25. 13-25 Form 990 Information Return Requires financial statement information similar to that required by GAAP. The 990 also provides information to make sure the organization is still operating in accordance with its exempt mission. Also discloses information about the compensation of the highest paid employees and contractors. Taxpayer Bill of Rights 2 (1996) requires that 990s must be made available to those who request it – they are most commonly posted to a web site.

26. 13-26 Types of Forms 990 Form 990: Titled “Return of Organization Exempt from Income Tax” this return provides the public with financial information and is also used by the IRS with information to monitor the activities of tax exempt organizations. Form 990-EZ: Shorter than the Form 990, this is available for tax exempt not-for-profits with annual gross receipts under $ 500,000 and total assets of less than $2.5 million. Form 990-N: This “electronic postcard” is available for tax exempt not-for-profits with annual gross receipts under $ 50,000 ($ 25,000 for tax years prior to 2011).

27. 13-27 Unrelated Business Income Tax Tax-exempt organizations are required to pay tax (at the corporate rate) on income generated from a trade or business unrelated to the entity’s tax-exempt purposes The purpose of the tax is to prevent nonprofits from having an “unfair” tax advantage over business enterprises with competing goods and services

28. 13-28 Unrelated Business Income Tax Even unrelated business income will be exempt from income tax if the activity is: Not carried on regularly Run by volunteers Involves sales of donated items Operated for convenience of employees and patrons.

29. 13-29 Income Exempt from UBIT Some income is given specific exemption: Royalties, dividends, interest and annuities Research revenues Income from public entertainment at a fair Revenues from labor, agriculture, or business trade shows Income from rental or exchange of membership lists

30. 13-30 Part 3: Performance Evaluation

31. 13-31 Common size analysis In common size analysis, all items on a financial statement are scaled, typically by the largest amount appearing on that statement. Items on balance sheets are divided by total assets Items appearing on operating statements are commonly divided by total revenues These amounts are then compared to: Earlier years Other governments Financial ratios are used to convert information to a more understandable form. The most straightforward form of ratio analysis is common size analysis.

32. 13-32 Performance Evaluation - Ratios To compare entities of varying size, it is useful to compute financial ratios The relevance of financial ratios depends on the type of organization: Not-for-profit Ratios Governmental Ratios

33. 13-33 Not-for-Profit Ratios A. Program Expense Ratio: Program Service Expenses Total Expenses What proportion of each dollar is used on programs? B. Fundraising Efficiency: Fundraising Expenses Contribution Revenue How much does it cost to raise a dollar of contributions?

34. 13-34 Not-for-Profit Ratios, cont’d C. Working Capital Ratio (Current Assets – Current Liabilities) Total Expenses If multiply by 12 months: How many months of operating expenses are available in working capital?

35. 13-35 Governments: Users of Financial Statements Citizens/voters Legislative and oversight officials Investors and Creditors

36. 13-36 Bond Markets and Financial Analysis The CAFR is a major data source for professional bond rating agencies such as Moody’s, Standard and Poor’s, Fitch’s Investors Services Bonds are rated from Aaa to C The financial condition of state and local governments affects the cost of debt and/or bond insurance.

37. 13-37 Common Financial Ratios – Financial position Government-wide statements (governmental activities) Unrestricted Net Position: Total Expenses: Governmental Activities General Fund fund-basis statements Unassigned Fund Balance Total Expenditures + Other Financing Uses This ratio may be calculated on government- wide or fund level This is a measure of the availability of resources to meet expenses. Larger values indicate stronger financial condition.

38. 13-38 Common Financial Ratios – Liquidity: Quick Ratio Cash + Current Investments Current Liabilities A measure of the government’s ability to finance short-term obligations. Higher values indicate greater liquidity.

39. 13-39 Common Financial Ratios – Solvency - Leverage Total Liabilities – Deferred Outflows Total Assets – Deferred Inflows This should be measured on the government-wide level since governmental funds do not report long- term liabilities A measure of the proportion of a government’s assets that are financed with debt. Small values indicate greater solvency.

40. 13-40 Common Financial Ratios – Solvency - Coverage ratio – debt service coverage Enterprise fund Statement of Cash Flows: Cash Flows from Operations Interest Paid + Payments of Principal This ratio may only be directly measured for the enterprise funds since those funds prepare statements of cash flow Indicates the availability of cash generated to meet current obligations on outstanding debt. Higher values indicate greater solvency

41. 13-41 Common Financial Ratios – Solvency - Debt service to total expenditures Principal and Interest Expenditure Total Expenditures: General and Debt Service Fund This information is drawn from the fund- basis financial statements of the governmental type funds A measure of the degree to which governmental expenditures are committed to debt service. Low values indicate greater flexibility and ability to manage additional debt.

42. 13-42 Ability to Pay Debt per capita Total Liabilities Population This should be measured on the government-wide level since governmental funds do not report long-term liabilities A measure of the government’s ability to service debt or incur additional debt. Low values indicate greater flexibility and ability to manage additional debt.

43. 13-43 Ability to Pay Debt to assessed value of property Total Liabilities Assessed Value of Property This should be measured on the government-wide level since governmental funds do not report long-term liabilities A measure of the government’s ability to service debt or incur additional debt. Low values indicate greater flexibility and ability to manage additional debt.

44. 13-44 Service Efforts and Accomplishments Reporting Because the bottom line is not a good indicator of government performance, governments often provide non-financial performance measures.

45. 13-45 SEA Levels of Reporting Input – resources dedicated to a problem Output – the quantity of service provided Outcome – the extent to which results are achieved or needs are satisfied Efficiency – relate costs (inputs) to output measures Cost Outcome – relate inputs to outcomes