Risks of Not-for-Profit and Government Audits

By Gartland, Daniel J. | Journal of Accountancy, April 2016 | Go to article overview

Risks of Not-for-Profit and Government Audits


Gartland, Daniel J., Journal of Accountancy


The number 90,056: What does it represent? It's the total of the 3,031 counties, 12,880 independent school districts, 16,360 townships, 19,519 municipalities, and 38,266 special districts--all the local governments in the United States, according to the U.S. Census Bureau's 2012 "Census of Governments." Add to that more than 1.5 million tax-exempt organizations in the United States as of 2015, according to the National Center for Charitable Statistics, and you have a staggering number of potential clients for CPA firms.

Many government and not-for-profit (NFP) organizations require an audit. And since the fiscal year end for many of these organizations is something other than Dec. 31, this type of service presents an opportunity for CPA firms to shift work outside of the traditional busy season. Additionally, these engagements provide audit staff with fresh experiences and industry exposure. The benefits of providing audit services to government and NFP organizations are numerous, yet they may present unforeseen professional liability risks for firms without the necessary knowledge and expertise in these specialized areas.

While claims related to audit services have historically accounted for approximately 8% to 12% of all claims reported to the AICPA Professional Liability Insurance Program, they are the most severe, meaning amounts incurred in defense and settlement costs are usually greater than claims related to other services provided by CPA firms. This degree of claim severity is related to several factors: the high level of assurance provided by an audit, the complexity of issues that the auditor must address, and the reliance on the financial statements by third parties, such as investors, creditors, suppliers, and donors, as well as the client.

For example, audits of governmental and NFP entities generally involve planning, testing, and reporting requirements mandated by regulators. The regulator may oversee and scrutinize the auditor's compliance with those requirements. Uncertainty may arise on government audits where changes in key personnel and procedures can be affected by an election cycle. Moreover, audit reports for government and NFP entities may be available to a broad audience including the general public, constituents, donors, or even beneficiaries of an NFP.

WHERE DO PROBLEMS OCCUR?

Claims relating to the performance of government and NFP audits frequently allege the CPA failed to detect or report a defalcation or a misstatement in the financial statements. How can these allegations affect the CPA? Perhaps there is an undetected error in the financial statements, or the client failed to comply with special reporting or donor requirements. This may lead to the loss of federal awards or pledged funds, which may affect the entity's operations and ability to serve its constituents. An NFP entity may even have to shut down. The client, and affected third parties, may then place responsibility for these woes on the CPA firm, citing the audit failure.

Consider the following claim scenario:

A CPA firm was engaged to audit a local governmental entity. The engagement continued over several years, and unqualified opinions were rendered. One year, a qualified opinion was issued when it was determined the entity had misallocated funds from a restricted-use tax levy. The proceeds from the tax levy should have been used to service loan and other obligations but instead were used to pay general expenses.

Recent funding reductions had already stretched the entity's budget, and the issuance of a modified opinion raised the question of eligibility for funds previously awarded. A claim was brought against the CPA firm, alleging that it should have detected the misallocation of funds in prior years. Expert review of the audit working papers and firm records uncovered an audit team member's noncompliance with continuing professional education requirements and lack of industry experience. …

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