This is the accessible text file for Section 200 of GAO report number 
GAO-01-765G entitled 'Financial Audit Manual: Volumes 1 and 2' which 
was released on August 01, 2001 and updated by GAO-03-466G entitled 
'Financial Audit Manual: Update to Part II - Tools' which was released 
on April 01, 2003 and by GAO report number GAO-04-1015G entitled 
'GAO/PCIE: Financial Audit Manual: Update' which was released on July 
01, 2004.

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SECTION 200:

Planning Phase:

Table 1: Methodology Overview:

Planning Phase:

* Understand the entity's operations: 220; 

* Perform preliminary analytical procedures: 225; 

* Determine planning, design, and test materiality: 230; 

* Identify significant line items, accounts, assertions, and RSSI: 235;
 
* Identify significant cycles, accounting applications, and financial 
management systems: 240; 

* Identify significant provisions of laws and regulations: 245; 

* Identify relevant budget restrictions: 250; 

* Identify risk factors: 260; 

* Determine likelihood of effective information system controls: 270; 

* Identify relevant operations controls to evaluate and test: 275; 

* Plan other audit procedures: 280; 

* Plan locations to visit: 285.

Internal Control Phase:

* Understand information systems: 320; 

* Identify control objectives: 330; 

* Identify and understand relevant control activities: 340; 

* Determine the nature, timing, and extent of control tests and of 
tests for systems' compliance with FFMIA requirements: 350;
 
* Perform nonsampling control tests and tests for systems' compliance 
with FFMIA requirements: 360; 

* Assess controls on a preliminary basis: 370.

Testing Phase:

* Consider the nature, timing, and extent of tests: 420; 

* Design efficient tests: 430; 

* Perform tests and evaluate results: 440; 

* Sampling control tests: 450; 

* Compliance tests: 460; 

* Substantive tests: 470; 

* Substantive analytical procedures: 475; 

* Substantive detail tests: 480.

Reporting Phase: Section:

* Perform overall analytical procedures: 520; 

* Determine adequacy of audit procedures and audit scope: 530; 

* Evaluate misstatements: 540; 

* Conclude other audit procedures: 550; 

* Inquire of attorneys; 

* Consider subsequent events; 

* Obtain management representations; 

* Consider related party transactions; 

* Determine conformity with generally accepted accounting 
principles: 560; 

* Determine compliance with GAO/PCIE Financial Audit Manual: 570; 

* Draft reports: 580.

[End of table]

Planning Phase: 

210: Overview:

.01: The auditor performs planning to determine an effective and 
efficient way to obtain the evidential matter necessary to report on 
the entity's Accountability Report (or annual financial statement). 
The nature, extent, and timing of planning varies with, for example, 
the entity's size and complexity, the auditor's experience with the 
entity, and the auditor's knowledge of the entity's operations. 
Procedures performed in the planning phase are shown in figure 200.1.

.02: 
A key to a quality audit, planning requires the involvement of senior 
members of the audit team. Although concentrated in the planning phase, 
planning is an iterative process performed throughout the audit. For 
example, findings from the internal control phase directly affect 
planning the substantive audit procedures. Also, the results of control 
and substantive tests may require changes in the planned audit 
approach.

.03: 
Auditors should consider the needs of, and consult in a timely manner 
with, other auditors who plan to use the work being performed, 
especially when making decisions that require the auditor to exercise 
significant judgment.

[End of section]

Planning Phase: 

220: Understand the Entity's Operations:

.01: 
The auditor should obtain an understanding of the entity sufficient to 
plan and perform the audit in accordance with applicable auditing 
standards and requirements. In planning the audit, the auditor gathers 
information to obtain an overall understanding of the entity and its 
origin and history, size and location, organization, mission, business, 
strategies, inherent risks, fraud risks, control environment, risk 
assessment, communications, and monitoring. Understanding the entity's 
operations in the planning process enables the auditor to identify, 
respond to, and resolve accounting and auditing problems early in the 
audit.

.02: 
The auditor's understanding of the entity and its operations does not 
need to be comprehensive but should include:

* entity management and organization,

* external factors affecting operations,

* internal factors affecting operations, and:

* accounting policies and issues.

.03: 
The auditor should identify key members of management and obtain a 
general understanding of the organizational structure. The auditor's 
main objective is to understand how the entity is managed and how the 
organization is structured for the particular management style.

.04: 
The auditor should identify significant external and internal factors 
that affect the entity's operations. External factors might include (1) 
source(s) of funds, (2) seasonal fluctuations, (3) current political 
climate, and (4) relevant legislation. Internal factors might include 
(1) size of the entity, (2) number of locations, (3) structure of the 
entity (centralized or decentralized), (4) complexity of operations, 
(5) information system structure, (6) qualifications and competence of 
key personnel, and (7) turnover of key personnel.

.05: 
In identifying accounting policies and issues, the auditor should 
consider:

* generally accepted accounting principles, including whether the 
entity is likely to be in compliance;

* changes in GAAP that affect the entity; and:

* whether entity management appears to follow aggressive or 
conservative accounting policies.

.06:
The auditor also should consider whether the entity will report any 
required supplementary stewardship information (RSSI). This includes 
stewardship property, plant, and equipment (PP&E) (heritage assets, 
national defense assets, and stewardship land), stewardship investments 
(nonfederal physical property, human capital, and research and 
development), social insurance, and risk-assumed information. RSSI and 
deferred maintenance, which is considered required supplementary 
information, should be designated "unaudited."

.07:
The auditor should develop and document a high-level understanding of 
the entity's use of information systems (IS) and how IS affect the 
generation of financial statement information, RSSI, and the data that 
support performance measures reported in the MD&A (overview) of the 
Accountability Report (CFO report). An IS auditor may assist the 
auditor in understanding the entity's use of IS. Appendix I of the GAO 
Federal Information System Controls Manual (FISCAM) can be used to 
document this understanding.

.08:
The auditor gathers planning information through different methods 
(observation, interviews, reading policy and procedure manuals, etc.) 
and from a variety of sources, including:

* top-level entity management,

* entity management responsible for significant programs,

* Office of Inspector General (IG) and internal audit management 
(including any internal control officer),

* others in the audit organization concerning other completed, planned 
or in-progress assignments,

* personnel in OGC,

* personnel in the Special Investigator Unit, and:

* entity legal representatives.

.09: 
The auditor gathers information from relevant reports and articles 
issued by or about the entity, including:

* the entity's prior Accountability Reports;

* other financial information;

* FMFIA reports and supporting documentation;

* reports by management or the auditor about systems' substantial 
compliance with FFMIA requirements;

* the entity's budget and related reports on budget execution;

* GAO reports;

* IG and internal audit reports (including those for performance audits 
and other reviews);

* congressional hearings and reports;

* consultant reports; and:

* material published about the entity in newspapers, magazines, internet 
sites, and other publications.

[End of section]

Planning Phase: 

225 - PERFORM PRELIMINARY ANALYTICAL PROCEDURES:

.01: During the planning phase, preliminary analytical procedures are 
performed to help the auditor:

* understand the entity's business, including current-year transactions 
and events;

* identify account balances, transactions, ratios, or trends that may 
signal inherent or control risks, including any risks related to fraud 
(see section 260);

* identify and understand the significant accounting policies;

* determine planning, design, and test materiality (see section 230); 
and:

* determine the nature, timing, and extent of audit procedures to be 
performed.

.02: GAAS requires the auditor to perform preliminary analytical 
procedures (AU 329). The resources spent in performing these procedures 
should be commensurate with the expected reliability of comparative 
information. For example, in a first-year audit, comparative 
information might be unreliable; therefore, preliminary analytical 
procedures generally should be limited.

.03: The auditor generally should perform the following steps to 
achieve the objectives of preliminary analytical procedures:

a. Compare current-year amounts with relevant comparative financial 
information: The financial data used in preliminary analytical 
procedures generally are summarized at a high level, such as the level 
of financial statements. If financial statements are not available, the 
budget or financial summaries that show the entity's financial position 
and results of operations may be used.

The auditor compares current-year amounts with relevant comparative 
financial information. Use of unaudited comparative data might not 
allow the auditor to identify significant fluctuations, particularly if 
an item consistently has been treated incorrectly. Also, the auditor 
may identify fluctuations that are not really fluctuations due to 
errors in the unaudited comparative data.

A key to effective preliminary analytical procedures is to use 
information that is comparable in terms of the time period presented 
and the presentation (i.e., same level of detail and consistent 
grouping of detail accounts into summarized amounts used for 
comparison).

The auditor may perform ratio analysis on current-year data and compare 
the current year's ratios with those derived from prior periods or 
budgets. The auditor does this to study the relationships among 
components of the financial statements and to increase knowledge of the 
entity's activities. The auditor uses ratios that are relevant 
indicators or measures for the entity. Also, the auditor should 
consider any trends in the performance indicators prepared by the 
entity.

b. Identify significant fluctuations: Fluctuations are differences 
between the recorded amounts and the amounts expected by the auditor, 
based on comparative financial information and the auditor's knowledge 
of the entity. Fluctuations refer to both unexpected differences 
between current-year amounts and comparative financial information as 
well as the absence of expected differences. The identification of 
fluctuations is a matter of the auditor's judgment.

The auditor establishes parameters for identifying significant 
fluctuations. When setting these parameters, the auditor generally 
considers the amount of the fluctuation in terms of absolute size and/
or the percentage difference. The amount and percentage used are left 
to the auditor's judgment. An example of a parameter is "All 
fluctuations in excess of $10 million and/or 15 percent of the prior-
year balance or other unusual fluctuations will be considered 
significant."

c. Inquire about significant fluctuations: The auditor discusses the 
identified fluctuations with appropriate entity personnel. The focus of 
the discussion is to achieve the purposes of the procedures described 
in paragraph 225.01. For preliminary analytical procedures, the auditor 
does not need to corroborate the explanations since they will be tested 
later. However, the explanations should appear reasonable and 
consistent to the auditor. The inability of entity personnel to explain 
the cause of a fluctuation may indicate the existence of control, 
fraud, and/or inherent risks.

.04: In performing preliminary analytical procedures, the auditor 
develops expectations about plausible relationships that are expected 
to exist. Because these procedures generally use data aggregated at a 
high level, their results typically provide only a broad initial 
indication about a potential misstatement. The auditor should consider 
any unusual relationships, together with other information gathered, in 
identifying the risk of material misstatement due to fraud (see section 
260).

[End of section]

Planning Phase: 

230: Determine Planning, Design, and Test Materiality:

.01: 
Materiality is one of several tools the auditor uses to determine that 
the planned nature, timing, and extent of procedures are appropriate. 
As defined in Financial Accounting Standards Board (FASB) Statement of 
Financial Concepts No. 2., materiality represents the magnitude of an 
omission or misstatement of an item in a financial report that, in 
light of surrounding circumstances, makes it probable that the judgment 
of a reasonable person relying on the information would have been 
changed or influenced by the inclusion or correction of the item.

.02: 
Materiality is based on the concept that items of little importance, 
which do not affect the judgment or conduct of a reasonable user, do 
not require auditor investigation. Materiality has both quantitative 
and qualitative aspects. Even though quantitatively immaterial, certain 
types of misstatements could have a material impact on or warrant 
disclosure in the financial statements for qualitative reasons.

.03: 
For example, intentional misstatements or omissions (fraud) usually are 
more critical to the financial statement users than are unintentional 
errors of equal amounts. This is because the users generally consider 
an intentional misstatement more serious than clerical errors of the 
same amount.

.04: 
GAGAS and incorporated GAAS require the auditor to consider materiality 
in planning, designing procedures, and considering need for disclosure 
in the audit report. AU 312 requires the auditor, in planning the 
audit, to consider his/her preliminary judgment about materiality 
levels. The "yellow book" states that materiality is a matter of 
professional judgment influenced by the needs of the reasonable person 
relying on the financial statements. Materiality judgments are made in 
the light of surrounding circumstances and involve both quantitative 
and qualitative considerations, such as the public accountability of 
the auditee and the visibility and sensitivity of government programs, 
activities, and functions.

.05: 
The term "materiality" can have several meanings. In planning and 
performing the audit, the auditor uses the following terms that relate 
to materiality:

* Planning materiality is a preliminary estimate of materiality, in 
relation to the financial statements taken as a whole, used to 
determine the nature, timing, and extent of substantive audit 
procedures and to identify significant laws and regulations for 
compliance testing.

* Design Materiality is the portion of planning materiality that has 
been allocated to line items, accounts, or classes of transactions 
(such as disbursements). This amount will be the same for all line 
items or accounts (except for certain intragovernmental or offsetting 
balances as discussed in paragraph 230.10).

* Test materiality is the materiality actually used by the auditor in 
testing a specific line item, account, or class of transactions. Based 
on the auditor's judgment, test materiality can be equal to or less 
than design materiality, as discussed in paragraph 230.13. Test 
materiality may be different for different line items or accounts.

.06:
The following other uses of the term "materiality" relate principally 
to the reporting phase:

* Disclosure materiality is the threshold for determining whether an 
item should be reported or presented separately in the financial 
statements or in the related notes. This value may differ from 
planning materiality.

* FMFIA materiality is the threshold for determining whether a matter 
meets OMB criteria for reporting matters under FMFIA as described in 
paragraphs 580.35-.37.

* Reporting materiality is the threshold for determining whether an 
unqualified opinion can be issued. In the reporting phase, the auditor 
considers whether unadjusted misstatements are quantitatively or 
qualitatively material. If considered to be material, the auditor would 
be precluded from issuing an unqualified opinion on the financial 
statements. See section 540.

Unless otherwise specified, such as through using the terms above, the 
term "materiality" in this manual refers to the overall financial 
statement materiality as defined in paragraph 230.01.

.07: 
The following guidelines provide the auditor with a framework for 
determining planning materiality. However, this framework is not a 
substitute for professional judgment. The auditor has the flexibility 
to determine planning materiality outside of these guidelines. In such 
circumstances, the Audit Director should discuss the basis for the 
determination with the Reviewer. The planning materiality selected and 
method of determining planning materiality should be documented and 
approved by the Audit Director.

.08: 
The auditor should estimate planning materiality in relation to the 
element of the financial statements that is most significant to the 
primary users of the statements (the materiality base). The auditor 
uses judgment in determining the appropriate element of the financial 
statements to use as the materiality base. Also, since the materiality 
base normally is based on unaudited preliminary information determined 
in the planning phase, the auditor usually has to estimate the year-end 
balance of the materiality base. To provide reasonable assurance that 
sufficient audit procedures are performed, any estimate of the 
materiality base should use the low end of the range of estimated 
materiality so that sufficient testing is performed.

.09:
For capital-intensive entities, total assets may be an appropriate 
materiality base. For expenditure-intensive entities, total expenses 
may be an appropriate materiality base. Based on these concepts, the 
materiality base generally should be the greater of total assets or 
expenses (net of adjustments for intragovernmental balances and 
offsetting balances). (See discussion of these adjustments in next 
paragraph.) Other materiality bases that might be considered include 
total liabilities, equity, revenues, and net cost to the government 
(appropriations).

.10: 
In considering a materiality base, the auditor should consider how to 
handle significant intragovernmental balances (such as funds with the 
U.S. Treasury, U.S. Treasury securities, and interentity balances) and 
offsetting balances (such as future funding sources that offset certain 
liabilities and collections that are offset by transfers to other 
government entities). The auditor should establish a separate 
materiality base for significant intragovernmental or offsetting 
balances because combining all accounts may improperly distort the 
nature, timing, and extent of audit procedures. For example, an entity 
that collects and remits funds on behalf of other federal entities 
could have operating accounts that are small in comparison to the funds 
processed on behalf of other entities. In this example, the auditor 
would compute separate planning materiality for auditing (1) the 
offsetting accounts, using the balance of the offsetting accounts as 
the materiality base and (2) the rest of the financial statements using 
the materiality base guidance in paragraph 230.09.

.11: 
Planning materiality generally should be 3 percent of the materiality 
base. Although a mechanical means might be used to compute planning 
materiality, the auditor should use judgment in evaluating whether the 
computed level is appropriate. The auditor also should consider 
adjusting the materiality base for the impact of such items as 
unrecorded liabilities, contingencies, and other items that are not 
incorporated in the entity's financial statements (and not reflected in 
the materiality base) but that may be important to the financial 
statement user.

.12: 
Design materiality for the audit should be one-third of planning 
materiality to allow for the precision of audit procedures. This 
guideline recognizes that misstatements may occur throughout the 
entity's various accounts. The design materiality represents the 
materiality used as a starting point to design audit procedures for 
line items or accounts so that an aggregate material misstatement in 
the financial statements will be detected, for a given level of audit 
assurance (discussed in paragraph 260.04).

.13: 
Generally, the test materiality used for a specific test is the same as 
the design materiality. However, the auditor may use a test materiality 
lower than the design materiality for substantive testing of specific 
line items and assertions (which increases the extent of testing) when:

* the audit is being performed at some, but not all, entity locations 
(requiring increased audit assurance for those locations visited - see 
section 285);

* the area tested is deemed to be sensitive to the financial statement 
users; or:

* the auditor expects to find a significant amount of misstatements.
[Footnote 1]

FOOTNOTES: 

[1] If the auditor uses software to calculate sample size, he or she 
should understand how the software considers expected misstatements. 
For example, if the auditor uses Interactive Data Extraction and 
Analysis (IDEA) to calculate sample size when test materiality is lower 
than design materiality, because the auditor expects misstatements, the 
auditor should use design materiality in IDEA because he or she 
separately inputs the expected misstatement. See paragraph 480.27.

[End of section]

Planning Phase: 

235: Identify Significant Line Items, Accounts, Assertions, and RSSI:

.01: 
The auditor should identify significant line items and accounts in the 
financial statements and significant related financial statement 
assertions. The auditor should also identify significant RSSI.[Footnote 
1] In the internal control and testing phases, the auditor performs 
control and substantive tests for each significant assertion for each 
significant account. By identifying significant line items, accounts, 
and the related assertions early in the planning process, the auditor 
is more likely to design efficient audit procedures. Some insignificant 
line items, accounts, and assertions may not warrant substantive audit 
tests to the extent that they are not significant in the aggregate. 
However, some line items and accounts with zero or unusual balances may 
warrant testing, especially with regard to the completeness assertion.

.02: 
Financial statement assertions, as defined by AU 326, are management 
representations that are embodied in financial statement components. 
Most of the auditor's work in forming an opinion on financial 
statements consists of obtaining and evaluating evidential matter 
concerning the assertions in such financial statements. The assertions 
can be either explicit or implicit and can be classified into the 
following broad categories:

* Existence or occurrence: An entity's assets or liabilities exist at a 
given date, and recorded transactions have occurred during a given 
period.

* Completeness: All transactions and accounts that should be presented 
in the financial statements are so included.

* Rights and obligations: Assets are the rights of the entity, and 
liabilities are the obligations of the entity at a given date.

* Valuation or allocation: Asset, liability, revenue, and expense 
components have been included in the financial statements at 
appropriate amounts.

* Presentation and disclosure: The particular components of the 
financial statements are properly classified, described, and disclosed.

.03: 
A line item or an account in the financial statements or RSSI should be 
considered significant if it has one or more of the following 
characteristics:

* Its balance is material (exceeds design materiality) or comprises a 
significant portion of a material financial statement or RSSI amount.

* A high combined risk (inherent and control risk, as discussed in 
paragraph 260.02) of material misstatement (either overstatement or 
understatement) is associated with one or more assertions relating to 
the line item or account. For example, a zero or unusually small 
balance account may have a high risk of material understatement.

* Special audit concerns, such as regulatory requirements, warrant 
added consideration.

The auditor should determine that any accounts considered insignificant 
are not significant in the aggregate.

.04: 
An assertion is significant if misstatements in the assertion could 
exceed test materiality for the related line item, account, or 
disclosure. Certain assertions for a specific line item or account, 
such as completeness and disclosure, could be significant even though 
the recorded balance of the related line item or account is not 
material. For example, (1) the completeness assertion could be 
significant for an accrued payroll account with a high combined risk of 
material understatement even if its recorded balance is zero and (2) 
the disclosure assertion could be significant for a contingent 
liability even if no amount is recordable.

.05: 
Assertions are likely to vary in degree of significance, and some 
assertions may be insignificant or irrelevant for a given line item or 
account. For example:

* The completeness assertion for liabilities may be of greater 
significance than the existence assertion for liabilities.

* All assertions related to an account that is not significant (as 
defined in paragraph 235.03) are considered to be insignificant.

The rights and obligations assertion for a revenue or expense account 
is irrelevant.

.06: Significant line items, accounts, and assertions should be 
identified in the Account Risk Analysis (ARA) or other appropriate 
audit planning workpapers.

FOOTNOTES: 

[1] The auditor is not required to opine on RSSI, but, per OMB audit 
guidance, internal control over RSSI should be tested the same as 
internal control over the financial statements.

[End of section]

Planning Phase: 

240: Identify Significant Cycles, Accounting Applications, and 
Financial Management Systems:

.01:
In the internal control phase, the auditor evaluates controls for each 
significant cycle and accounting application and determines whether 
significant financial management systems substantially comply with 
federal financial management systems requirements, federal accounting 
standards, and the SGL at the transaction level. A cycle or an 
accounting application should be considered significant if it processes 
an amount of transactions in excess of design materiality or if it 
supports a significant account balance in the financial statements or 
significant RSSI. A financial management system generally consists of 
one or more accounting applications. If one or more of the accounting 
applications making up a financial management system are considered 
significant, then that financial management system generally should be 
considered significant for determining whether the system substantially 
complies with FFMIA requirements. The auditor may identify other 
cycles, accounting applications, or financial management systems as 
significant based on qualitative considerations. For example, financial 
management systems covered by FFMIA include not only systems involved 
in processing financial transactions and preparing financial 
statements, but also systems supporting financial planning, management 
reporting, or budgeting activities, systems accumulating and reporting 
cost information, and the financial portion of mixed systems, such as 
benefit payment, logistics, personnel, and acquisition systems.

.02: 
The entity's accounting system may be viewed as consisting of logical 
groupings of related transactions and activities, or accounting 
applications. Each significant line item/account is affected by input 
from one or more accounting applications (sources of debits or 
credits). Related accounting applications may be grouped into cycles by 
the auditor and into financial management systems by the entity. 
Accounting applications are classified as (1) transaction-related or 
(2) line item/account-related.

.03: 
A transaction-related accounting application consists of the methods 
and records established to identify, assemble, analyze, classify, and 
record (in the general ledger) a particular type of transaction. 
Typical transaction-related accounting applications include billing, 
cash receipts, purchasing, cash disbursements, and payroll. A line 
item/account-related accounting application consists of the methods and 
records established to report an entity's recorded transactions and to 
maintain accountability for related assets and liabilities. Typical 
line item/account-related accounting applications include cash 
balances, accounts receivable, inventory control, property and 
equipment, and accounts payable.

.04: 
Within a given entity, there may be several examples of each accounting 
application. For example, a different billing application may exist for 
each program that uses a billing process. Accounting applications that 
process a related group of transactions and accounts comprise cycles. 
For instance, the billing, returns, cash receipts, and accounts 
receivable accounting applications might be grouped to form the revenue 
cycle. Similarly, related accounting applications also comprise 
financial management systems.

.05: 
For each significant line item and account, the auditor should use the 
Account Risk Analysis form (ARA) (see section 395 I) or an equivalent 
workpaper to document the significant transaction cycles (such as 
revenue, purchasing, and production) and the specific significant 
accounting applications that affect these significant line items and 
accounts. For example, the auditor might determine that billing, 
returns, cash receipts, and accounts receivable are significant 
accounting applications that affect accounts receivable (a significant 
line item). The Account Risk Analysis form provides a convenient way 
for documenting the specific risks of misstatement for significant line 
items for consideration in determining the nature, timing, and extent 
of audit procedures. If an equivalent workpaper is used, rather than 
the ARA, it should document the information discussed in section 395 I.

.06: 
Related accounting applications may be grouped into cycles to aid in 
preparing workpapers. This helps the auditor design audit procedures 
that are both efficient and relevant to the reporting objectives. The 
auditor may document insignificant accounts in each line item on the 
ARA or equivalent, indicating their insignificance and consequent lack 
of audit procedures applied to them. In such instances, the cycle 
matrix may not be necessary. Otherwise, the auditor should prepare a 
cycle matrix or equivalent document that links each of the entity's 
accounts (in the chart of accounts) to a cycle, an accounting 
application, and a financial statement or RSSI line item.

.07: 
Based on discussions with entity personnel, the auditor should 
determine the accounting application that is the best source of the 
financial statement information. When a significant line item has more 
than one source of financial data, the auditor should consider the 
various sources and determine which is best for financial audit 
purposes. The auditor needs to consider the likelihood of misstatement 
and auditability in choosing the source to use. For audit purposes, the 
best source of financial information sometimes may be operational 
information prepared outside the accounting system.

.08: 
Once the significant accounting applications are identified, the 
auditor determines which computer systems are involved in those 
applications. Those particular computer systems are then considered in 
assessing computer-related controls using an appropriate methodology.

.09: 
An appropriate methodology would require the auditor to obtain 
sufficient knowledge of the information system relevant to financial 
reporting to understand the accounting processing from initiation of a 
transaction to its inclusion in the financial statements, including 
electronic means used to transmit, process, maintain, and access 
information (see AU 319.49, SAS 94). AU 319.61 requires documentation 
of this understanding. OMB audit guidance notes that the components of 
internal control include general and application controls. General 
controls are the entitywide security management program, access 
control, application software development and change control, system 
software control, segregation of duties, and service continuity 
control. Application controls are authorization control, completeness 
control, accuracy control, and control over integrity of processing and 
data files. OMB audit guidance also requires that, for controls that 
have been properly designed and placed in operation, the auditor shall 
perform sufficient tests to support a low assessed level of control 
risk. The auditor should document the basis for believing that the 
methodology used is appropriate to satisfy these requirements for 
assessing general and application controls. The GAO Federal Information 
System Controls Audit Manual (FISCAM) is designed to meet these 
requirements. See section 295 J for a flowchart of steps generally 
followed in assessing information system controls in a financial 
statement audit. IS security controls are also addressed in OMB 
Circular A-130, Management of Federal Information Resources, in the 
National Institute of Standards and Technology's An Introduction to 
Computer Security: The NIST Handbook, and in other publications.

[End of section]

Planning Phase: 

245: Identify Significant Provisions of Laws and Regulations:

.01: 
To design relevant compliance-related audit procedures, the auditor 
identifies the significant provisions of laws and regulations. To aid 
the auditor in this process, this manual classifies provisions of laws 
and regulations into the following categories:

* Transaction-based provisions are those for which compliance is 
determined on individual transactions. For example, the Prompt Payment 
Act requires that late payments be individually identified and interest 
paid on such late payments.

* Quantitative-based provisions are those that require the accumulation/
summarization of quantitative information for measurement. These 
provisions may contain minimum, maximum, or targeted amounts 
(restrictions) for the accumulated/summarized information. For 
example, the Comprehensive Environmental Response, Compensation, and 
Liability Act of 1980 prohibits the Environmental Protection Agency 
from exceeding certain spending limits on specific projects.

* Procedural-based provisions are those that require the entity to 
implement policies or procedures to achieve certain objectives. For 
example, the Single Audit Act, as amended, requires the awarding entity 
to review certain financial information on awardees.

.02: 
The auditor should identify the significant provisions of laws and 
regulations. For each significant provision, the auditor should study 
and evaluate related compliance controls and should test compliance 
with the provision. To identify such significant provisions, the 
auditor should take these steps:

a. The auditor should review the lists of laws and regulations that OMB 
and the entity have determined might be significant to others. The OMB 
list is provided in an appendix of OMB's audit guidance and is included 
in section 295 H. The entity is expected to develop a list that, for 
CFO Act agencies and components listed in OMB audit guidance, should 
include laws and regulations in OMB audit guidance, whether or not they 
are material to the entity, because they have been determined to be 
material to the consolidated financial statements of the United States 
Government. In addition, the auditor should identify (with OGC 
assistance) any laws or regulations (in addition to those identified by 
OMB and the entity) that have a direct effect on determining amounts in 
the financial statements. The meaning of direct effect is discussed 
below in paragraph 245.03.

b. For each such law or regulation, the auditor should identify those 
provisions that are significant. A provision should be considered 
significant if (1) compliance with the provision can be measured 
objectively and (2) it meets one of the following criteria for 
determining that the provision has a material effect on determining 
financial statement amounts:

* Transaction-based provisions: Transactions processed by the entity 
that are subject to the provision exceed planning materiality in the 
aggregate.

* Quantitative-based provisions: The quantitative information required 
by the provision or by established restrictions exceeds planning 
materiality.

* Procedural-based provisions: The provision broadly affects all or a 
segment of the entity's operations that process transactions exceeding 
planning materiality in the aggregate. For example, a provision may 
require that the entity establish procedures to monitor the receipt of 
certain information from grantees; in determining whether to test 
compliance with this provision, the auditor should consider whether the 
total amount of money granted exceeded planning materiality.

.03: A direct effect means that the provision specifies:

* the nature and/or dollar amount of transactions that may be incurred 
(such as obligation, outlay, or borrowing restrictions),

* the method used to record such transactions (such as revenue 
recognition policies), or:

* the nature and extent of information to be reported or disclosed in the 
annual financial statements (such as the statement of budgetary 
resources).

For example, entity-enabling legislation may contain provisions that 
limit the nature and amount of obligations or outlays and therefore 
have a direct effect on determining amounts in the financial 
statements. If a provision's effect on the financial statements is 
limited to contingent liabilities as a result of noncompliance 
(typically for fines, penalties, and interest), such a provision does 
not have a direct effect on determining financial statement amounts. 
Laws identified by the auditor that have a direct effect might include 
(1) new laws and regulations (not yet reflected on OMB's list) and (2) 
entity-specific laws and regulations. The concept of direct effect is 
discussed in AU 801 (SAS 74) and AU 317.

.04: 
In contrast, indirect laws relate more to the entity's operating 
aspects than to its financial and accounting aspects, and their 
financial statement effect is indirect. In other words, their effect 
may be limited to recording or disclosing liabilities arising from 
noncompliance. Examples of indirect laws and regulations include those 
related to environmental protection and occupational safety and health.

.05: 
The auditor is not responsible for testing compliance controls over or 
compliance with any indirect laws and regulations not otherwise 
identified by OMB or the entity (see paragraph 245.02.a.). However, as 
discussed in AU 317, the auditor should make inquiries of management 
regarding policies and procedures for the prevention of noncompliance 
with indirect laws and regulations. Unless possible instances of 
noncompliance with indirect laws or regulations come to the auditor's 
attention during the audit, no further procedures with respect to 
indirect laws and regulations are necessary.

.06: 
The auditor may elect to test compliance with indirect laws and 
regulations. For example, if the auditor becomes aware that the entity 
has operations similar to those of another entity that was recently in 
noncompliance with environmental laws and regulations, the auditor may 
elect to test compliance with such laws and regulations. The auditor 
may also elect to test provisions of direct laws and regulations that 
do not meet the materiality criteria in paragraph 245.02.b. but that 
are deemed significant, such as laws and regulations that have 
generated significant interest by the Congress, the media, or the 
public.

.07: 
The significant provisions identified by the above procedures are 
intended to include provisions of all laws and regulations that have a 
direct and material effect on the determining of financial statement 
amounts and therefore comply with GAGAS, AU 801 (SAS 74), and OMB audit 
guidance.

.08: 
In considering regulations to test for compliance, the auditor should 
consider externally imposed requirements issued pursuant to the 
Administrative Procedures Act, which has a defined due process. This 
would include regulations in the Code of Federal Regulations, but would 
not include OMB circulars and bulletins. Such circulars and bulletins 
generally implement laws, and the provisions of the laws themselves 
could be considered for compliance testing. Internal policies, manuals, 
and directives may be the basis for internal controls, but are not 
regulations to consider for testing for compliance.

[End of section]

Planning Phase: 

250: Identify Relevant Budget Restrictions:

.01: To evaluate budget controls (see section 295 G) and to design 
compliance-related audit procedures relevant to budget restrictions, 
the auditor should understand the following information (which may be 
obtained from the entity or OGC):

* the Antideficiency Act (title 31 of the U.S. Code, sections 1341, 
1342, 1349-1351, 1511-1519);

* the Purpose Statute (title 31 of the U.S. Code, section 1301);

* the Time Statute (title 31 of the U.S. Code, section 1502);

* OMB Circular A-34;

* title 7 of the GAO Policy and Procedures Manual for Guidance of Federal 
Agencies;

* the Impoundment Control Act; and:

* the Federal Credit Reform Act of 1990.

.02: The auditor should read the following information relating to the 
entity's appropriation (or other budget authority) for the period of 
audit interest:

* authorizing legislation;

* enabling legislation and amendments;

* appropriation legislation and supplemental appropriation legislation;

* apportionments and budget execution reports (including OMB forms 132 
and 133 and supporting documentation);

* Impoundment Control Act reports regarding rescissions and deferrals, 
if any;

* the system of funds control document approved by OMB; and:

* any other information deemed by the auditor to be relevant to 
understanding the entity's budget authority, such as legislative 
history contained in committee reports or conference reports.

Although legislative histories are not legally binding, they may help 
the auditor understand the political environment surrounding the entity 
(i.e., why the entity has undertaken certain activities and the 
objectives of these activities).

.03: Through discussions with OGC and the entity and by using the above 
information, the auditor should identify all legally binding 
restrictions on the entity's use of appropriated funds that are 
relevant to budget execution, such as restrictions on the amount, 
purpose, or timing of obligations and outlays ("relevant budget 
restrictions"). Additionally, the auditor should consider any legally 
binding restrictions that the entity has established in its fund 
control regulations, such as lowering the legally binding level for 
compliance with the Antideficiency Act to the allotment level.

.04: 
The auditor should obtain an understanding of the implications if the 
entity were to violate these relevant budget restrictions. In the 
internal control phase, the auditor identifies and tests the entity's 
controls to prevent or detect noncompliance with these relevant 
restrictions. The auditor may elect to evaluate controls over budget 
restrictions that are not legally binding but that may be considered 
sensitive or otherwise important.

.05: 
During these discussions with OGC and the entity, the auditor should 
determine whether any of these relevant budget restrictions relate to 
significant provisions of laws and regulations for purposes of testing 
compliance.

.06: 
For those entities that do not receive appropriated funds, the auditor 
should identify budget-related requirements that are legally binding on 
the entity. These requirements, if any, are usually found in the 
legislation that created the entity or its programs (such as the 
authorizing and enabling legislation) as well as any subsequent 
amendments. Although budget information on these entities may be 
included in the President's budget submitted to the Congress, this 
information usually is not legally binding. In general, certain budget-
related restrictions (such as the Antideficiency Act) apply to 
government corporations but not to government-sponsored enterprises. 
Regardless, the auditor should consider the entity's budget formulation 
and execution as part of the control environment, as discussed in 
section 260.

[End of section]

Planning Phase:

260 - IDENTIFY RISK FACTORS:

.01: The auditor's consideration of inherent risk, fraud risk, control 
environment, risk assessment, communication, and monitoring (parts of 
internal control) affects the nature, timing, and extent of substantive 
and control tests. This section describes (1) the impact of risk 
factors identified during this consideration on substantive and control 
tests, (2) the process for identifying these risk factors, and (3) the 
auditor's consideration of the entity's process for reporting under 
FMFIA (both for internal control (section 2 of FMFIA) and for financial 
management systems' conformance with system requirements (section 4 of 
FMFIA) and for formulating the budget.

IMPACT ON SUBSTANTIVE TESTING:

.02: AU 312 provides guidance on the consideration of audit risk and 
defines "audit risk" as the risk that the auditor may unknowingly fail 
to appropriately modify an opinion on financial statements that are 
materially misstated. Audit risk can be thought of in terms of the 
following three component risks:

* Inherent risk is the susceptibility of an assertion to a material 
misstatement, assuming that there are no related internal controls.

* Control risk is the risk that a material misstatement that could 
occur in an assertion will not be prevented or detected and corrected 
on a timely basis by the entity's internal control. Internal control 
consists of five components: (1) the control environment, (2) risk 
assessment, (3) monitoring, (4) information and communication, and (5) 
control activities (defined in paragraph 260.08 below). This section 
will discuss the first three of the components and communication, which 
is part of the fourth component. Section 300 (Internal Control Phase) 
will discuss the information systems and control activities.

* Detection risk is the risk that the auditor will not detect a 
material misstatement that exists in an assertion.

AU 316 requires the auditor to consider fraud risk, which is a part of 
audit risk, making up a portion of inherent and control risk. Fraud 
risk consists of the risk of fraudulent financial reporting and the 
risk of misappropriation of assets that cause a material misstatement 
of the generated may be too voluminous to allow effective manual 
review. The auditor should specifically consider and document the risk 
of material misstatements of the financial statements due to fraud and 
keep in mind the consideration of fraud risk in designing audit 
procedures. Considering the risk of material fraud generally should be 
done concurrently with the consideration of inherent and control risk, 
but it should be a separate conclusion. The auditor also should consider 
the risk of fraud throughout the audit. Section 290 includes 
documentation requirements for the consideration of fraud risk.

.03: 
Based on the level of audit risk and an assessment of the entity's 
inherent and control risk, including the consideration of fraud risk, 
the auditor determines the nature, timing, and extent of substantive 
audit procedures necessary to achieve the resultant detection risk. For 
example, in response to a high level of inherent and control risk, the 
auditor may perform:

* additional audit procedures that provide more competent evidential 
matter (nature of procedures);

* substantive tests at or closer to the financial statement date (timing 
of procedures); or:

* more extensive substantive tests (extent of procedures), as discussed 
in section 295 E.

.04: 
Audit assurance is the complement of audit risk. The auditor can 
determine the level of audit assurance obtained by subtracting the 
audit risk from 1. (Assurance equals 1 minus risk).[Footnote 1] AU 
350.48 uses 5 percent as the allowable audit risk in explaining the 
audit risk model (95 percent audit assurance). The audit organization 
should determine the level of assurance to use, which may vary between 
audits based on risk. GAO auditors should use 95 percent. In other 
words, the GAO auditor, in order to provide an opinion, should design 
the audit to achieve at least 95 percent audit assurance that the 
financial statements are not materially misstated (5 percent audit 
risk). Section 470 provides guidance to the auditor on how to combine 
(1) the assessment of inherent and control risk (including fraud risk) 
and (2) substantive tests to achieve the audit assurance required by 
the audit organization.

.05: 
The auditor may consider it necessary to achieve increased audit 
assurance if the entity is politically sensitive or if the Congress has 
expressed concerns about the entity's financial reporting. In this 
case, the level of audit assurance should be approved by the Reviewer.

RELATIONSHIP TO CONTROL ASSESSMENT:

.06: 
Internal control, as identified in AU 319 (SAS 55 amended by SAS 78), 
is a process--effected by an entity's governing body, management, and 
other personnel--designed to provide reasonable assurance regarding the 
achievement of objectives in the following categories (OMB audit 
guidance expands the category definitions as noted):[Footnote 2]

* Reliability of financial reporting--transactions are properly 
recorded, processed, and summarized to permit the preparation of the 
financial statements and RSSI in accordance with generally accepted 
accounting principles, and assets are safeguarded against loss from 
unauthorized acquisition, use, or disposition. (Note that safeguarding 
controls (see paragraphs 310.02-.04) are considered as part of 
financial reporting controls, although they are also operations 
controls.)

* Compliance with applicable laws and regulations--transactions are 
executed in accordance with (a) laws governing the use of budget 
authority and other laws and regulations that could have a direct and 
material effect on the financial statements or RSSI, and (b) any other 
laws, regulations, and governmentwide policies identified by OMB in its 
audit guidance. (Note that budget controls are part of financial 
reporting controls as they relate to the statements of budgetary 
resources and of financing, but that they are also part of compliance 
controls in that they are used to manage and control the use of 
appropriated funds and other forms of budget authority in accordance 
with applicable law. These controls are described in more detail in 
section 295 G.)

* Effectiveness and efficiency of operations. These controls include 
policies and procedures to carry out organizational objectives, such as 
planning, productivity, programmatic, quality, economy, efficiency, 
and effectiveness objectives. Management uses these controls to provide 
reasonable assurance that the entity (1) achieves its mission, 
(2) maintains quality standards, and (3) does what management directs 
it to do. (Note that performance measures controls (those designed to 
provide reasonable assurance about reliability of performance 
reporting--transactions and other data that support reported 
performance measures are properly recorded, processed, and summarized 
to permit the preparation of performance information in accordance with 
criteria stated by management) are included in operations controls.)

.07: 
Some control policies and procedures belong in more than one category 
of control. For example, financial reporting controls include controls 
over the completeness and accuracy of inventory records. Such controls 
are also necessary to provide complete and accurate inventory records 
to allow management to analyze and monitor inventory levels to better 
control operations and make procurement decisions (operations 
controls).

.08: 
The five components of internal control relate to objectives that an 
entity strives to achieve in each of the three categories: financial 
reporting (including safeguarding), compliance, and operations 
(including performance measures) controls. The components are defined 
in AU 319 as:

* The control environment sets the tone of an organization, influencing 
the control consciousness of its people. It is the foundation for all 
other components of internal control, providing discipline and 
structure.

* Risk assessment is the entity's identification and analysis of 
relevant risks to achievement of its objectives, forming a basis for 
determining how the risks should be managed.

* Information and communication are the identification, capture, and 
exchange of information in a form and time frame that enable employees 
to carry out their responsibilities.

* Monitoring is a process that assesses the quality of internal control 
performance over time.

* Control activities are the policies and procedures that help ensure 
that management directives are carried out.

PROCESS FOR IDENTIFYING RISK FACTORS:

.09: In the planning phase, the auditor should (1) identify conditions 
that significantly increase inherent, fraud, and control risk (based on 
identified control environment, risk assessment, communication, or 
monitoring weaknesses) and (2) conclude whether any identified control 
risks preclude the effectiveness of specific control activities in 
significant applications. The auditor identifies specific inherent 
risks, fraud risks, and control environment, risk assessment, 
communication, and monitoring weaknesses based on information obtained 
earlier in the planning phase, primarily from understanding the 
entity's operations and preliminary analytical procedures. The auditor 
considers factors such as those listed in paragraphs 260.16-.51 in 
identifying such risks and weaknesses. These factors are general in 
nature and require the auditor's judgment in determining (1) the extent 
of procedures (testing) to identify the risks and weaknesses and (2) 
the impact of such risks and weaknesses on the entity and its financial 
statements. Because this risk consideration requires the exercise of 
significant audit judgment, it should be performed by experienced audit 
team personnel.

.10: 
The auditor considers the implications of these risk factors on related 
operations controls. For example, inherent risk may be associated with 
a material liability for loan guarantees because it is subject to 
significant management judgment. In light of this inherent risk, the 
entity should have strong operations controls to monitor the entity's 
exposure to losses from loan guarantees. Potential weaknesses in such 
operations controls could significantly affect the ultimate program 
cost. Therefore, the need for operations controls in a particular area 
or the awareness of operations control weaknesses related to these risk 
factors should be identified and considered for further review, as 
discussed in section 275.

.11: 
Specific conditions that may indicate inherent or fraud risks or 
control environment, risk assessment, communication, or monitoring 
weaknesses are provided in sections 295 A and 295 B, respectively. 
These sections are designed to aid the auditor in identifying these 
risks and weaknesses but are not intended to be all inclusive. The 
auditor should consider any other factors and conditions deemed 
relevant.

.12: 
The auditor identifies and documents any significant risk factors after 
considering (1) his/her knowledge of the entity (obtained in previous 
steps in the planning phase); (2) the risk factors discussed in 
paragraphs 260.16-.51 and in sections 295 A and 295 B; and (3) other 
relevant factors. These risks and weaknesses and their impact on 
proposed audit procedures should be documented on the General Risk 
Analysis (GRA) or equivalent (see section 290). The auditor also should 
summarize and document any account-specific risks on the Account Risk 
Analysis (ARA) or equivalent (see sections 290 and 395 I).

.13: 
For each risk factor identified, the auditor documents the nature and 
extent of the risk or weakness; the condition(s) that gave rise to that 
risk or weakness; and the specific cycles, accounts, line items, and 
related assertions affected (if not pervasive). For example, the 
auditor may identify a significant risk that the valuation of the net 
receivables line item could contain a material misstatement due to (1) 
the materiality of the receivables and potential allowance, (2) the 
subjectivity of management's judgment related to the loss allowance 
(inherent risk), and (3) management's history of aggressively 
challenging any proposed adjustments to the valuation of the 
receivables (control environment weakness). The auditor should also 
document other considerations that may mitigate the effects of 
identified risks and weaknesses. For example, the use of a lock box (a 
control activity) may mitigate inherent risks associated with the 
completeness of cash receipts.

.14: 
The auditor also should document, in the GRA or equivalent, the overall 
effectiveness of the control environment, risk assessment, 
communication, and monitoring, including whether weaknesses preclude 
the effectiveness of specific control activities. The focus should be 
on management's overall attitude, awareness, and actions, rather than 
on specific conditions related to a control environment, risk 
assessment, communication, or monitoring factor. This assessment will 
be considered when determining the control risk associated with the 
entity.

.15: 
In assessing the control environment, risk assessment, communication, 
and monitoring, the auditor should specifically assess the quality of 
the entity's process for compliance with FMFIA (see paragraphs 260.43-
.47) and should obtain an overall understanding of the budget 
formulation process (see paragraph 260.51).

INHERENT RISK FACTORS:

.16: 
Inherent risk factors incorporate characteristics of an entity, a 
transaction, or account that exist due to:

* the nature of the entity's programs,

* the prior history of audit adjustments, or:

* the nature of material transactions and accounts.

The assessment of inherent risk generally should be limited to 
significant programs, transactions, or accounts. For each factor listed 
below, section 295 A lists conditions that may indicate inherent risk.

a. Nature of the entity's programs: The mission/business of an entity 
includes the implementation of various programs or services. The 
characteristics of these programs or services affect the entity's 
susceptibility to errors and fraud and sensitivity to changes in 
economic conditions. For example, student loan guarantee programs may 
be more susceptible to errors and fraud because of loans issued and 
serviced by third parties.

b. Prior history of significant audit adjustments: Significant audit 
adjustments identified in previous financial statement audits or other 
audits often identify problem areas that may result in financial 
statement misstatements. For example, the prior year's audit may have 
identified the necessity for recording a contingent liability as the 
result of certain economic conditions. The auditor could then focus on:

* determining whether similar conditions continue to exist;

* understanding management's response to such conditions (including 
implementation of controls), if any; and:

* assessing the nature and extent of the related inherent risk.

c. Nature of material transactions and accounts: The nature of an 
entity's transactions and accounts has a direct relation to the risk of 
errors or fraud. For example, accounts involving subjective management 
judgments, such as loss allowances, are usually of higher risk than 
those involving objective determinations.

INFORMATION SYSTEMS (IS) EFFECTS ON INHERENT RISK:

.17: Information systems (IS) do not affect the audit objectives for an 
account or a cycle. However, IS can introduce inherent risk factors not 
present in a manual accounting system. The auditor should (1) consider 
each of the following IS factors and (2) assess the overall impact of 
IS processing on inherent risk. The impact of these factors typically 
will be pervasive in nature. An IS auditor may assist the auditor in 
considering these factors and making this assessment. More detail on 
assessing IS controls in a financial statement audit is available in 
FISCAM, and a flowchart of the steps to follow is in section 295 J.

a. Uniform processing of transactions: Because IS process groups of 
identical transactions consistently, any misstatements arising from 
erroneous computer programming will occur consistently in similar 
transactions. However, the possibility of random processing errors is 
reduced substantially in computer-based information systems.

b. Automatic processing: The information system may automatically 
initiate transactions or perform processing functions. Evidence of 
these processing steps (and any related controls) may or may not be 
visible.

c. Increased potential for undetected misstatements: Computers use and 
store information in electronic form and require less human involvement 
in processing. This increases the potential for individuals to gain 
unauthorized access to sensitive information and to alter data without 
visible evidence. Due to the electronic form, changes to computer 
programs and data are not readily detectible. Also, users may be less 
likely to challenge the reliability of computer output than manual 
reports.

d. Existence, completeness, and volume of the audit trail: The audit 
trail is the evidence that demonstrates how a specific transaction was 
initiated, processed, and summarized. For example, the audit trail for 
a purchase could include a purchase order, a receiving report, an 
invoice, invoice register (purchases summarized by day, month, and/or 
account), and general ledger postings from the invoice register. Some 
computerized financial management systems are designed so that the 
audit trail exists for only a short period (such as in on-line 
systems), only in an electronic format, or only in summary form. Also, 
the information generated may be too voluminous to allow effective 
manual review. For example, one posting to the general ledger may 
result from the computer summarization of information from hundreds of 
locations.

e. Nature of the hardware and software used in IS: The nature of the 
hardware and software can affect inherent risk, as illustrated below:

* The type of computer processing (on-line, batch-oriented, or 
distributed) presents different levels of inherent risk. For example, 
the inherent risk of unauthorized transactions and data entry errors 
may be greater for on-line processing than for batch-oriented 
processing.

* Peripheral access devices or system interfaces can increase inherent 
risk. For example, Internet and dial-up access to a system increases 
the system's accessibility to additional persons and therefore 
increases the risk of unauthorized access to computer resources.

* Distributed networks enable multiple computer processing units to 
communicate with each other, increasing the risk of unauthorized access 
to computer resources and possible data alteration. On the other hand, 
distributed networks may decrease the risk of conflicting computerized 
data between multiple processing units.

* Applications software developed in-house may have higher inherent 
risk than vendor-supplied software that has been thoroughly tested and 
is in general commercial use.

f. Unusual or nonroutine transactions: As with manual systems, unusual 
or nonroutine transactions increase inherent risk. Programs developed 
to process such transactions may not be subject to the same procedures 
as programs developed to process routine transactions. For example, the 
entity may use a utility program to extract specified information in 
support of a nonroutine management decision.

FRAUD RISKS:

.18: The auditor has a responsibility to plan and perform the audit to 
obtain reasonable assurance about whether the financial statements are 
free of material misstatement, whether caused by error or fraud. 
Accordingly, the auditor is concerned with the risk of material 
misstatement due to fraud (fraud risk). The primary factor that 
distinguishes fraud from error is that the action causing the 
misstatement in fraud is intentional. (See section 230 related to 
materiality, including quantitative and qualitative considerations.)

.19: Two types of misstatements are relevant to the auditor's 
consideration of fraud in an audit of financial statements--
misstatements arising from fraudulent financial reporting and 
misstatements arising from misappropriation of assets. Misstatements 
arising from fraudulent financial reporting are intentional 
misstatements or omissions of amounts or disclosures in financial 
statements to deceive financial statement users. They could involve 
intentional alteration of accounting records, misrepresentation of 
transactions, intentional misapplication of accounting principles, or 
other means. Misstatements arising from misappropriation of assets 
involve theft of an entity's assets that result in misstatements in the 
financial statements. They could involve theft of property, 
embezzlement of receipts, fraudulent payments, or other means. (See 
section 310 for internal control over safeguarding assets. Safeguarding 
controls relate to protecting assets against loss from unauthorized 
acquisition, use, or disposition.)

.20: In considering misstatements arising from misappropriation of 
assets, the auditor should consider fraud risks associated with 
improper payments. Some of the improper payments made by federal 
government entities could involve fraud. The Improper Payments 
Information Act of 2002 (P.L. 107-300) defines improper payments as any 
payment that should not have been made or that was made in an incorrect 
amount (including overpayments and underpayments) under statutory, 
contractual, administrative, or other legally applicable requirements. 
The act requires agency heads to annually review all programs and 
activities that they administer, identify those that might be 
susceptible to significant improper payments, [Footnote 3] estimate 
annual improper payments for those identified programs, and--for 
programs for which estimated improper payments exceed $10 million--
report certain information to the Congress. Although the act has this 
reporting threshold, the auditor might consider improper payments 
amounting to $10 million or less quantitatively or qualitatively 
material.

.21: As discussed in paragraph .18, the auditor is responsible for 
obtaining reasonable, but not absolute, assurance about whether the 
financial statements are free of material misstatement. Absolute 
assurance cannot be attained, and the auditor's report does not provide 
absolute assurance. A properly planned and performed audit might not 
detect a material misstatement, and the subsequent discovery of a 
material misstatement does not, in and of itself, provide evidence that 
the auditor did not conform with auditing standards.

.22: In addition, the auditor should be alert to situations or 
transactions that could be indicative of abuse. Abuse is distinct from 
fraud and illegal acts. Abuse involves behavior that is deficient or 
improper (but not necessarily fraudulent or illegal) when compared with 
behavior that a prudent person would consider reasonable and necessary 
business practice given the facts and circumstances. The auditor is not 
required to detect abuse. However, if indications of abuse that could 
result in material misstatement of the financial statements or other 
financial data come to the auditor's attention, the auditor should 
apply audit procedures specifically directed to determine whether abuse 
has occurred and the effect, if any, on the financial statements. The 
auditor should consider both quantitative and qualitative factors in 
making judgments about the materiality of possible abuse and about 
related audit procedures. The determination of abuse is subjective, and 
the auditor does not provide reasonable assurance of detecting abuse. 
(See GAGAS, paragraphs 4.19-.20.)

Characteristics of Fraud:

.23: Three conditions generally are present when fraud occurs:

* Incentive/Pressure--Management, other employees, or external parties 
(for example, for some improper payments) have an incentive or are 
under pressure, which provides a motive to commit fraud.

* Opportunity--Circumstances exist, such as the absence of controls, 
ineffective controls, or the ability of management to override 
controls, that provide an opportunity to commit fraud.

* Attitude/Rationalization--Individuals involved are able to 
rationalize committing fraud. Some individuals possess an attitude, 
character, or ethical values that allow them to knowingly and 
intentionally commit a dishonest act.

Generally, the greater the incentive or pressure, the more likely an 
individual will be able to rationalize the acceptability of committing 
fraud.

.24: Management is in a position that could permit it to perpetrate 
fraud by directly or indirectly manipulating accounting records; 
overriding controls, sometimes in unpredictable ways; or committing 
other fraudulent or improper acts.

Fraud Risk Factors:

.25: Although fraud is usually concealed, the presence of fraud risk 
factors that indicate incentive/pressure, opportunity, or attitude/
rationalization might alert the auditor to a significant risk of fraud. 
However, fraud risk factors do not necessarily indicate that fraud 
exists. Examples of fraud risk factors, classified by the two types of 
fraudulent misstatements and then by these three conditions, include 
the following:

a. Examples related to misstatements arising from fraudulent financial 
reporting:

* Incentive/Pressure--Incentive exists for management to report reduced 
program costs or costs that are consistent with budgeted amounts, or 
excessive pressure exists to meet unrealistic deadlines or other 
requirements.

* Opportunity--Key financial statement amounts are based on significant 
estimates that involve subjective judgments or uncertainties that are 
difficult to corroborate, or management is in a position to override 
controls for processing adjustments or unusual transactions.

* Attitude/Rationalization--Employees perceive that penalties exist 
for reporting honest results, or employees consider requirements such 
as performance targets unrealistic.

b. Examples related to misstatements arising from misappropriation of 
assets:

* Incentive/Pressure--Employees who are disgruntled because of 
impending layoffs have an incentive to misappropriate assets, or 
pressure to meet programmatic objectives such as for rapid benefit 
payments increases the risk of fraudulent improper payments.

* Opportunity--Employees have access to assets that are small in size 
and valuable or the authority to disburse funds, or a program has 
weaknesses in internal control related to fraudulent improper payments.

* Attitude/Rationalization--Employees believe that management is 
unethical, or individuals believe they are entitled to the entity's 
assets.

Fraud risk factors represent inherent or control risk factors. As 
discussed in paragraph .02, the auditor should consider fraud risk 
factors in assessing inherent and control risk. Sections 295A and 295B 
include additional examples of fraud risk factors.

Professional Skepticism:

.26: The auditor should exercise professional skepticism--an attitude 
that includes a questioning mind and a critical assessment of audit 
evidence--throughout the audit. The auditor should maintain a mindset 
that recognizes the possibility that a material misstatement due to 
fraud might be present, regardless of any past experience with the 
entity and regardless of the auditor's belief about management's 
honesty and integrity.

Brainstorming Meeting(s) about Potential Fraud Risks:

.27: Audit team members should exchange ideas in one or more 
"brainstorming" meeting(s) to identify potential fraud risks. They 
should discuss how and where the financial statements could be 
susceptible to material fraudulent misstatement, how management could 
perpetrate and conceal fraudulent financial reporting, how assets could 
be misappropriated (including through fraudulent improper payments), 
how management could override controls, and how the auditor might 
respond to these risks. They also should consider known internal and 
external fraud risk factors (including any related to fraudulent 
improper payments) and categorize these factors by type of misstatement 
and by incentive/pressure, opportunity, and attitude/rationalization. 
The brainstorming discussion should emphasize the need to exercise 
professional skepticism in gathering and evaluating evidence throughout 
the audit.

.28: The Audit Director, Assistant Director, and all other team members 
who have significant responsibilities in planning and performing the 
audit should participate in brainstorming, which may be performed in a 
single meeting or in multiple meetings. While different members may 
participate in different meetings, each brainstorming meeting should 
include at least one experienced team member, and all team members 
should be familiar with the collective results of the brainstorming 
meeting(s). Determining the brainstorming participants (for example, it 
might be useful to include stakeholders and specialists, such as IS 
auditors) and the number of brainstorming meeting(s) are matters of 
auditor judgment.

.29: The auditor's consideration of fraud risks should be ongoing 
throughout the audit. Near the completion of fieldwork, the auditor 
should evaluate whether the audit test results indicate the need for a 
change in the assessment of the fraud risks made earlier or the need 
for additional or different audit procedures (see paragraphs 540.18-
.19). Accordingly, communications with the audit team members about 
fraud should occur as needed throughout the audit, and the auditor may 
hold multiple, periodic brainstorming meetings.

Information to Identify Fraud Risks:

.30: Fraud risks might be identified as a result of replies to 
inquiries. To obtain information about fraud risks, the auditor should 
inquire of management about:

* any knowledge of fraud or suspected fraud (including fraudulent 
improper payments), or related allegations;

* management's understanding of fraud risks, including any specific 
risks the entity has identified and any account balances or classes of 
transactions having likely fraud risks (including information about any 
fraudulent improper payments that the agency identified in making 
assessments related to the Improper Payments Information Act of 2002);

* any antifraud programs and controls the entity has established; 
[Footnote 4]

* the nature and extent that locations or business segments, if any, 
are monitored, and whether there are particular locations or segments 
for which fraud risks might be more likely;

* whether and how management communicates to employees its views on 
business practices and ethical behavior; and:

* whether management has reported to the audit committee (referred to 
as "financial management advisory committee" in some federal entities) 
or others with equivalent authority and responsibility on how the 
entity's internal control prevents, deters, or detects fraud.

.31: In addition to inquiring of management, inquiring of others might 
provide a different perspective or provide other important information. 
Accordingly, the auditor should perform the following inquiries and 
related procedures:

a. Obtain information about instances of fraud (including any related 
to fraudulent improper payments) reported by the inspector general, 
ordinarily by asking the Special Investigator Unit to summarize how 
cases of reported fraud were committed, and then ask management or the 
Office of Inspector General whether related controls have been 
strengthened.

b. Inquire of the audit committee or others with equivalent authority 
and responsibility about fraud risks and any fraud or suspected fraud, 
and obtain an understanding of how they exercise oversight.

c. Inquire of internal audit personnel about fraud risks, any 
procedures to detect fraud during the reporting period, management's 
response to any such findings, and any fraud or suspected fraud.

d. Inquire of other personnel about fraud or suspected fraud. The 
auditor should use judgment to determine whom to ask and the extent of 
inquiries. For example, the auditor may make inquiries of employees 
with varying levels of authority, operating personnel not directly 
involved in the financial reporting process, employees familiar with 
complex or unusual transactions or with improper payments, and in-house 
legal counsel.

e. If inconsistencies arise from the auditor's inquiries of management 
and others, obtain additional evidence to resolve the inconsistencies.

.32: The auditor also should perform the following procedures:

a. Obtain and review the agency's (1) plan to identify improper 
payments and (2) report, if any, on improper payments (or information 
about any findings) that resulted from the agency's review under the 
Improper Payments Information Act of 2002.

b. Determine whether preliminary analytical procedures disclosed any 
unusual or unexpected relationships that might indicate fraud risks. 
Where revenue is (or is expected to be) material, analytical procedures 
should include those related to revenue--for example, trend analysis--
to identify unusual or unexpected relationships that might indicate 
fraudulent financial reporting of revenue (see section 225 related to 
preliminary analytical procedures).

c. Consider whether any fraud risk factors exist (see paragraph .25).

d. Consider other information that might help identify fraud risks, 
such as information that resulted from previous audits, the 
brainstorming meeting(s), procedures related to accepting and 
continuing engagements, any reports on interim financial statements, 
and inherent risks identified at the account or transaction level.

Identification and Assessment of Fraud Risks:

.33: To identify fraud risks (including any related to fraudulent 
improper payments), the auditor should perform the following 
procedures:

a. Evaluate the information obtained in the procedures described in 
paragraphs .28-.32, in the context of the three conditions that 
generally are present when fraud occurs--incentive/pressure, 
opportunity, and attitude/rationalization. While fraud risk might be 
greatest when all three of these conditions are evident, observation of 
one or more of these conditions might indicate a fraud risk.

b. Where revenue is (or is expected to be) material, evaluate whether 
there are fraud risks related to revenue recognition (for example, 
through premature recognition or fictitious revenue). If the auditor 
concludes that improper revenue recognition does not represent a fraud 
risk, the auditor should document the reasons supporting that 
conclusion (see paragraph 290.04 h).

c. Evaluate the possibility that management could override controls, 
even if specific fraud risks have not been identified.

.34: For each identified fraud risk, the auditor should determine 
whether it relates to (1) specific financial statement account balances 
or classes of transactions and related assertions or (2) more 
pervasively to the financial statements as a whole. Generally, relating 
fraud risks to the individual accounts, classes of transactions, and 
assertions helps in designing audit procedures in response to these 
risks.

.35: As part of understanding internal control sufficient to plan the 
audit, the auditor should (1) evaluate whether programs and controls 
that address identified fraud risks have been suitably designed and 
placed in operation and (2) determine whether these programs and 
controls mitigate these risks or whether specific control deficiencies 
exacerbate these risks. See section 350 regarding testing the operating 
effectiveness of controls that are determined to mitigate these risks.

.36: The auditor should assess the identified fraud risks, taking into 
consideration the results of the procedures described in the preceding 
paragraph. In making this assessment, using professional judgment, the 
auditor should consider all significant aspects of each of these risks 
, including the type of misstatement, the significance and 
pervasiveness of the risk, and the likelihood that it could result in a 
material misstatement.

Response to Assessed Fraud Risks:

.37: The auditor must respond to the assessed risks of material 
misstatement due to fraud. The nature and significance of these fraud 
risks, as well as programs and controls that address identified fraud 
risks, influence the auditor's response. The auditor should use 
professional judgment in determining the appropriate response for the 
circumstances and exercise professional skepticism in gathering and 
evaluating audit evidence. The response should (1) have an overall 
effect on the conduct of the audit (see paragraph .39), (2) address 
fraud risks that relate to management override of controls (see 
paragraph .40), and, (3) for any of these risks that relate to specific 
financial statement account balances or classes of transactions and 
related assertions, involve the nature, timing, and extent of audit 
procedures (see paragraph .41). If it is not practicable, as part of a 
financial statement audit, to design audit procedures that sufficiently 
respond to the fraud risks, the auditor should consider requesting 
assistance from the Special Investigator Unit.

.38: In some instances, the audit plan could, for reasons other than 
responding to fraud risk, include procedures and personnel and 
supervisory assignments that are sufficient to respond to a fraud risk. 
In these instances, the auditor may conclude that no further response 
is required. For example, with respect to timing, audit procedures 
could be planned as of the date that the reporting period ends, both as 
a response to a fraud risk and for other reasons.

.39: The auditor should respond to the fraud risks in ways that have an 
overall effect on the conduct of the audit, as follows:

a. Assignment of personnel and supervision--Assign audit team staffing 
and/or supervision so that the knowledge, skill, and ability of 
personnel assigned significant responsibilities are commensurate with 
the auditor's assessment of the fraud risks--for example, the auditor 
may assign a fraud specialist or more experienced personnel or may 
increase supervision in response to identified fraud risks (also see 
section 270 related to IS auditors).

b. Review of accounting principles--Review management's selection and 
collective application of significant accounting principles, 
particularly those related to subjective measurements and complex 
transactions.

c. Unpredictability of audit procedures--Incorporate an element of 
unpredictability in the selection of audit procedures from reporting 
period to reporting period--for example, perform substantive tests of 
selected account balances and assertions not otherwise tested due to 
their materiality and risk, adjust the timing of audit tests, use a 
different method to select items for testing, or perform procedures at 
different locations or at locations on an unannounced basis. 
Statistical sampling selection usually provides an element of 
unpredictability as to the specific items tested (see section 480). 
Generally, the auditor should not inform entity personnel of specific 
audit procedures prior to performing them.

.40: The auditor should perform the following procedures to 
specifically address the risk that management can perpetrate fraud by 
overriding controls:

a. Examination of journal entries and other adjustments--Examine 
journal entries and other adjustments for evidence of possible material 
misstatement due to fraud. These include reclassifications, 
consolidating entries, and other routine and nonroutine journal entries 
and adjustments. The auditor should obtain an understanding of the 
financial reporting process and the controls over journal entries and 
other adjustments; identify and select journal entries and other 
adjustments for testing; determine the nature, timing, and extent of 
the testing (ordinarily including tests of journal entries and other 
adjustments at the end of the reporting period); and inquire of 
individuals involved in the financial reporting process about 
inappropriate or unusual activity related to the processing of journal 
entries and other adjustments.

b. Review of accounting estimates--Review accounting estimates for 
biases that could result in material misstatement due to fraud. In 
preparing financial statements, management is responsible for making 
judgments or assumptions that affect significant accounting estimates 
and for monitoring the reasonableness of these estimates on an ongoing 
basis. The auditor should consider whether differences between (1) 
estimates best supported by the evidence and (2) the estimates included 
in the financial statements, even if the estimates are individually 
reasonable, indicate possible bias by management, in which case the 
auditor should reconsider the estimates taken as a whole. The auditor 
also should perform a retrospective review of significant accounting 
estimates used in the prior year's financial statements, focusing on 
sensitive or subjective aspects, to determine whether they indicate 
possible bias by management. Further, the auditor should be alert for 
aggressive or inconsistently applied estimates.

c. Evaluation of business rationale for significant unusual 
transactions--Evaluate the business rationale for any significant 
unusual transactions, considering whether (1) the form of these 
transactions is overly complex, (2) management has discussed the nature 
of and accounting for these transactions with the audit committee or 
others with equivalent authority and responsibility or the board of 
directors, if any, (3) management is placing more emphasis on 
particular accounting treatments than on the underlying economics of 
the transactions, (4) transactions that involve related parties have 
been properly reviewed and approved by the audit committee or others 
with equivalent authority and responsibility or the board of directors, 
if any, and (5) the transactions involve previously unidentified 
related parties (see section 902) or related parties that do not have 
the substance or financial strength to support the transaction without 
assistance from the entity.

.41: For fraud risks related to specific financial statement account 
balances or classes of transactions and related assertions, the 
specific response will depend on the types of risks and the specific 
balances or classes and assertions, but it generally should involve 
both substantive and control tests. The response should involve the 
following:

a. Nature of audit procedures--for example, obtaining related evidence 
from independent external sources rather than internal sources;

b. Timing of audit procedures--for example, performing substantive 
testing at or near the end of the reporting period rather than at an 
interim date; and:

c. Extent of audit procedures--for example, increasing audit sample 
sizes.

Section 295 I provides additional examples of responses.

CONTROL ENVIRONMENT FACTORS:

.42: As discussed in AU 319 (SAS 55 amended by SAS 78), control environment 
risk factors incorporate management's attitude, awareness, and actions 
concerning the entity's control environment. These factors include:

* integrity and ethical values,

* commitment to competence,

* management's philosophy and operating style,

* organizational structure,

* assignment of authority and responsibility,

* human resource policies and practices,

* management's control methods over budget formulation and execution,

* management's control methods over compliance with laws and 
regulations, and:

* the functioning of oversight bodies (including congressional 
committees).

.43: The auditor should obtain sufficient knowledge of the control 
environment to determine whether the collective effect of these factors 
establishes, enhances, or mitigates the effectiveness of specific 
control activities. In making this determination, the auditor should 
consider the following factors and their effect on internal control. 
For each factor listed below, section 295 B lists conditions that may 
indicate control environment weaknesses.

a. Integrity and ethical values: Control effectiveness cannot rise above 
the integrity and ethical values of those who create, administer, and 
monitor the controls. Integrity and ethical values are essential 
elements of the control environment, affecting the design, 
administration, and monitoring of the other components. Integrity and 
ethical behavior result when the entity and its leaders have high 
ethical and behavioral standards and properly communicate them and 
reinforce them in practice. The standards include management's actions 
to remove or reduce incentives and temptations that might prompt 
personnel to engage in dishonest, illegal, or unethical acts. The 
communication of entity values and behavioral standards to personnel 
takes place through policy statements and codes of conduct and by 
example.

b. Commitment to competence: Competence is the knowledge and skills 
necessary to accomplish tasks required by an individual's job. 
Commitment to competence includes management's consideration of the 
competence levels for various jobs and the requisite skills and 
knowledge.

c. Management's philosophy and operating style: Management's philosophy 
and operating style encompass a broad range of beliefs, concepts, and 
attitudes. Such characteristics may include management's approach to 
taking and monitoring operational/program risks, attitudes and actions 
toward financial reporting, emphasis on meeting financial and operating 
goals, and management's attitude toward information processing, 
accounting, and personnel.

d. Organizational structure: An entity's organizational structure 
provides the overall framework for planning, directing, and controlling 
operations. The organizational structure should appropriately assign 
authority and responsibility within the entity. An organizational 
structure includes the form and nature of an entity's organizational 
units, including the data processing organization, and related 
management functions and reporting relationships.

e. Assignment of authority and responsibility: An entity's policies or 
procedures for assigning authority for operating activities and for 
delegating responsibility affect the understanding of established 
reporting relationships and responsibilities. This factor includes 
policies relating to appropriate business practices, knowledge and 
experience of key personnel, and resource allocations. It also includes 
policies and communications to ensure that all personnel understand the 
entity's objectives, how they contribute to these objectives, and how 
and for what they will be held accountable.

f. Human resource policies and practices: Human resource policies and 
practices affect an entity's ability to employ sufficient competent and 
trustworthy personnel to accomplish its goals and objectives. Such 
policies and practices include hiring, training, evaluating, promoting, 
compensating, and assisting employees in the performance of their 
assigned responsibilities by giving them the necessary resources.

g. Management's control methods over budget formulation and execution: 
Management's budget control methods affect the authorized use of 
appropriated funds. Budget formulation is discussed in more detail in 
paragraph 260.51, and controls over budget execution (budget controls) 
are addressed in more detail in section 300.

h. Management's control methods over compliance with laws and 
regulations: Such methods have a direct impact on an entity's 
compliance with applicable laws and regulations. (Compliance controls 
are addressed in more detail in section 300).

i. The functioning of oversight groups: An entity's oversight groups 
typically are responsible for overseeing both business activities and 
financial reporting. The effectiveness of an oversight group is 
influenced by its authority and its role in overseeing the entity's 
business activities. In the federal government, oversight groups are 
the Congress and the central agencies (OMB, Treasury, GSA, OPM, and 
GAO). Within agencies, senior management councils may also have a role 
in overseeing operations and programs.

RISK ASSESSMENT FACTORS:

.44: Risk assessment is an entity's internal process for identifying, 
analyzing, and managing risks relevant to achieving the objectives of 
reliable financial reporting, safeguarding of assets, and compliance 
with budget and other laws and regulations. For example, risk 
assessment may address how the entity analyzes significant estimates 
recorded in the financial statements or how it considers the 
possibility of unrecorded transactions. Risks can arise due to both 
internal and external circumstances such as:

* changes in the operating or statutory environment,

* new personnel who may have a different focus on internal control,

* new or significantly changed information systems,

* rapid growth of programs which can strain controls,

* new technology which may change risks,

* new programs or activities which may introduce new control risks,

* restructurings or budget cutbacks which may include downsizing and 
changes in supervision and segregation of duties, or:

* adoption of new accounting principles which may affect risks in 
preparing financial statements.

.45: The auditor should gain sufficient knowledge of the entity's risk 
assessment process to understand how management considers risks 
relevant to the objectives of financial reporting (including 
safeguarding), and compliance with budget and other laws and decides 
what actions to take. This understanding may include how management 
identifies risks, estimates their significance, assesses the likelihood 
of occurrence, and relates them to financial reporting.

COMMUNICATION FACTORS:

.46: 
Communication involves providing an understanding of individual roles 
and responsibilities pertaining to internal control. It includes the 
extent to which personnel understand how their activities relate to the 
work of others and the means of reporting exceptions to an appropriate 
higher level within the entity. Open communication channels help ensure 
that exceptions are reported and acted on. Communication takes such 
forms as policy manuals, accounting and financial reporting manuals, 
and memoranda. Communication also may be electronic, oral, and through 
the actions of management in demonstrating acceptable behavior.

.47: 
The auditor should obtain sufficient knowledge of the means the entity 
uses to communicate roles and responsibilities for, and significant 
matters relating to financial reporting, safeguarding, and compliance 
with budget and other laws and regulations.

MONITORING FACTORS:

.48: 
Monitoring is the process by which management assesses the quality of 
internal control performance over time. This may include ongoing 
activities, such as regular management and supervision, or 
communications from external parties, such as customer complaints or 
regulator comments that may indicate areas in need of improvement. This 
also may include separate evaluations, such as FMFIA work and IG or 
internal auditor work, or a combination of ongoing activities and 
separate evaluations.

.49: 
The auditor should gain sufficient knowledge of the major types of 
activities the entity uses to monitor internal control over financial 
reporting, including safeguarding, and compliance with budget and other 
laws and regulations and how those activities are used to initiate 
corrective actions.

.50: The IG's office or internal audit is often an important part of 
monitoring. The IG's office is responsible for (1) conducting and 
supervising audits and investigations relating to programs and 
operations, (2) providing leadership and coordination, including 
recommending policies for programs and operations, and (3) keeping the 
entity head and the Congress informed about problems and deficiencies, 
including the progress of corrective actions. The auditor should assess 
the effectiveness of the IG or internal audit as a monitoring control. 
However, if the auditor is the IG, the office should not attempt to 
assess its effectiveness as a control. Evaluating an IG's office or 
internal audit includes consideration of its authority and reporting 
relationships, the qualifications of its staff, and its resources. (In 
using the work of the IG or internal auditors, refer to section 650.)

IS EFFECTS ON THE CONTROL ENVIRONMENT, RISK ASSESSMENT, COMMUNICATION, 
AND MONITORING:

.51: IS affects the effectiveness of the control environment, risk 
assessment, communication, and monitoring. For example, controls that 
normally would be performed by separate individuals in manual systems 
may be concentrated in one computer application and pose a potential 
segregation-of-duties problem.

.52: The auditor should consider the following IS factors in making an 
overall assessment of the control environment, risk assessment, 
communication, and monitoring. An IS auditor may assist the auditor in 
considering these factors:

a. Management's attitudes and awareness with respect to IS: Management's 
interest in and awareness of IS functions is important in establishing 
an organizationwide consciousness of control issues. Management may 
demonstrate such interest and awareness by:

* considering the risks and benefits of computer applications;

* communicating policies regarding IS functions and responsibilities;

* overseeing policies and procedures for developing, modifying, 
maintaining, and using computers and for controlling access to programs 
and files;

* considering the inherent and control risk, including fraud risk, 
related to IS;

* responding to previous recommendations or concerns;

* quickly and effectively planning for, and responding to, computerized 
processing crises; and:

* depending on computer-generated information for key operating 
decisions.

b. Organization and structure of the IS function: The organizational 
structure affects the control environment. Centralized structures often 
have a single computer processing organization and use a single set of 
system and applications software, enabling tighter management control 
over IS. In decentralized structures, each computer center generally 
has its own computer processing organization, application programs, and 
system software, which may result in differences in policies and 
procedures and various levels of compliance at each location.

c. Clearly defined assignment of responsibilities and authority: 
Appropriate assignment of responsibility according to typical IS 
functional areas can affect the control environment. Factors to 
consider include:

* how the position of the Chief Information Officer (CIO) fits into the 
organizational structure;

* whether duties are appropriately segregated within the IS function, 
since lack of segregation typically affects all systems;

* the extent to which management external to the IS function is involved 
in major systems development decisions; and:

* the extent to which policies, standards, and procedures are documented, 
understood, followed, and enforced.

d. Management's ability to identify and to respond to potential risk: 
Computer processing, by its nature, introduces additional risk factors. 
The entity should be aware of these risks and should develop 
appropriate policies and procedures to respond to any IS issues that 
might occur. Factors to consider include:

* the methods for monitoring incompatible functions and for enforcing 
segregation of duties and:

* management's mechanism for identifying and responding to unusual or 
exceptional conditions.

FEDERAL MANAGERS' FINANCIAL INTEGRITY ACT OF 1982:

.53: 
In considering the control environment, risk assessment, communication, 
and monitoring, the auditor should assess the quality of the FMFIA 
process to provide evidence of management's control consciousness and 
the overall quality of the control environment, risk assessment, 
communication, and monitoring. In this regard, the quality of the FMFIA 
process is a good indicator of management's (1) philosophy and 
operating style, (2) assignment of authority and responsibility, and 
(3) control methods for monitoring and follow-up. The FMFIA process 
also may be the basis for management's assertion about the 
effectiveness of internal control (section 2) and about the entity's 
financial management systems' substantial compliance with FFMIA 
requirements (section 4).

.54: 
In considering the quality of the FMFIA process, the auditor generally 
should perform the following procedures. If the entity does not issue 
its own FMFIA report, the auditor should perform the following with 
respect to information the entity contributes to the FMFIA report in 
which the entity is included.

Read:

* the FMFIA report,

* important workpapers prepared by the entity in support of the FMFIA 
report,

* IG reports on FMFIA compliance,

* OMB's most recent annual letter concerning FMFIA reporting, and:

* management's description of the FMFIA process.

Discuss the FMFIA process with appropriate entity management (including 
management's opinion of the quality of the process).

Understand:

* how the FMFIA process is organized;

* who is assigned to manage the process, including the staffing level, 
experience and qualifications of assigned personnel, and reporting 
responsibilities; and:

* how the process finds and evaluates weaknesses.

* Identify the entity's actions on previously reported weaknesses and 
examine agency documentation that demonstrates the results/
effectiveness of those actions.

* Determine whether the audit finds different issues from those 
identified in the FMFIA process. (If so, see section 580 for reporting 
on FMFIA.)

.55: 
In assessing the quality of the FMFIA process, the auditor should 
consider whether management procedures and supporting documentation are 
sufficient to (1) provide management with reasonable assurance that 
FMFIA objectives have been achieved and (2) meet OMB requirements. This 
assessment is based on the auditor's overview and is not a result of 
extensive tests. Factors for the auditor to consider may include:

* evidence of efforts to rectify previously identified material 
weaknesses;

* management's commitment of resources to the FMFIA process, as 
reflected in the skills, objectivity, and number of personnel 
assigned to manage the process;

* extent to which management's methodology and assessment process 
conform to the guidance in Circulars A-123 ( June 21, 1995) and A-127 
(July 23, 1993 and revisions in Transmittal Memorandum No. 2, dated 
June 10, 1999) and related OMB guidelines;

* IG and internal auditor involvement (if any);

* the process used to identify and screen material weaknesses as FMFIA 
reports are consolidated and moved up the entity's hierarchy; and:

* the sources that identify material weaknesses, since items 
identified by management personnel, rather than from IG, GAO, or 
other external reports, demonstrate that the process can detect and 
report weaknesses.

.56: 
The auditor's assessment of the quality of the FMFIA process will 
affect the auditor's ability to use information in the FMFIA report and 
supporting documentation when identifying risks, testing controls, and 
preparing workpapers. The higher the quality of the FMFIA process, the 
more likely the auditor will be able to use the FMFIA findings in the 
financial audit. The auditor should document the assessment of the 
quality of the FMFIA process in the audit workpapers. Regardless, any 
material weaknesses identified in the FMFIA report should be considered 
in considering risk.

.57: 
The reliance that the auditor places on management's FMFIA work depends 
on a number of factors as discussed in FAM 650 (under revision).

Federal Financial Management Improvement Act of 1996:

.58: 
As part of its FMFIA work, management determines whether its financial 
management systems comply with the requirements found in OMB 
Circular A-127, Financial Management Systems. Under FFMIA, the auditor 
is required to report whether the financial management systems' 
substantially comply with those requirements. Further, OMB issues 
guidance that agencies and auditors should consider when addressing 
compliance with FFMIA.

.59: 
During the planning phase, the auditor generally should understand what 
management did to determine that the entity's systems were in 
substantial compliance in order to report under FMFIA. The entity may 
have used the OMB FFMIA guidance, the GAO Financial Management Series 
of checklists for Systems Reviewed Under the Federal Financial 
Management Improvement Act of 1996, the draft JFMIP Financial 
Management Systems Compliance Review Guide (http://www.financenet.gov/
financenet/fed/jfmip/fmscrg.pdf), or other tools. The auditor 
generally should review this documentation in the internal control 
phase of the audit to determine the degree to which he or she may rely 
on it as discussed in section 650 (under revision). (See section 320.)

.60: 
If the entity previously had an assessment made of its financial 
management systems' substantial compliance with these requirements that 
resulted in lack of substantial compliance, the auditor should read the 
remediation plan required by FFMIA and note whether the plan appears 
feasible and likely to remedy the deficiencies.

BUDGET FORMULATION:

.61: While assessing the control environment, risk assessment, 
communication, and monitoring, the auditor should obtain an overall 
understanding of the budget formulation process. The auditor does this 
to understand better how misstatements and internal control weaknesses 
affect the budget formulation process and, possibly, to consider the 
budget process as a control. Based on discussions with entity 
management responsible for the budget formulation process and review of 
budget documents, the auditor should consider:

* the entity's process for developing and summarizing the budget,

* the nature and sufficiency of instructions and training provided to 
individuals responsible for developing the budget,

* the extent that individuals involved in approving budget requests are 
also involved in the budget formulation process,

* the general extent to which the budget is based on historical 
information,

* the reliability of information on which the budget is based,

* the extent to which the budget formulation system is integrated with 
the budget execution system, and:

* the extent of correlation between information developed in the budget 
formulation process and the allotments and suballotments in the budget 
execution system.

FOOTNOTES: 

[1] Assurance is not the same as statistical confidence. Assurance is a 
combination of quantitative measurement and auditor judgment.

[2] See also GAO's Standards for Internal Control in the Federal 
Government, GAO/AIMD-00-21.3.1, November 1999.

[3] Agencies first need to determine which programs and activities are 
susceptible (at high risk) to improper payments. In determining this, 
OMB has issued guidance defining significant improper payments as those 
that exceed both 2.5 percent of program payments and $10 million. See 
OMB Memorandum M-03-13, Improper Payments Information Act of 2002, 
Public Law 107-300 (May 21, 2003).

[4] An example document, Management Antifraud Programs and Controls, 
commissioned by the Fraud Task Force of the Auditing Standards Board of 
the AICPA, is available at the AICPA's web site, www.aicpa.org.

[End of section]

Planning Phase: 

270 - DETERMINE LIKELIHOOD OF EFFECTIVE INFORMATION SYSTEM CONTROLS:

.01: 
Controls are considered IS controls if their effectiveness depends on 
computer processing. In the planning phase, the auditor (with the 
assistance of the IS auditor and using FISCAM or another appropriate 
methodology) should determine whether IS controls are likely to be 
effective and should therefore be considered in the internal control 
phase. The auditor may coordinate work done to meet the requirements of 
Division A, Title X, Subtitle G (Government Information Security 
Reform) of the National Defense Authorization Act for Fiscal Year 2001 
(P.L. 106-398) with work done as part of the financial statement audit. 
(See section 295 J for a flowchart of steps in assessing IS controls in 
a financial statement audit.) The procedures to be performed build on 
those procedures performed while understanding the entity's operations 
and assessing the effects of IS on inherent risk and the control 
environment, risk assessment, communication, and monitoring. AU 319 
(SAS 55, as amended by SAS 78 and SAS 94) requires the auditor to 
sufficiently understand each of the five components of internal 
control--control environment, risk assessment, information and 
communications, monitoring, and control activities--to plan the audit. 
This understanding should include relevant IS aspects.

.02: 
Computerized financial management systems are used extensively in the 
federal government. While many of these systems are mainframe based, 
numerous other technologies also exist. Some of these systems share 
programs and data files with one another. Others may be networked into 
major subsystems. In addition to producing financial and accounting 
information, such systems typically generate other information used in 
management decision-making.

.03: 
As discussed in paragraph 260.06, the auditor evaluates and tests the 
following types of controls in a financial statement audit:

* financial reporting controls,

* compliance controls, and:

* certain operations controls (to the extent described in section 275).

.04: 
For each of the controls to be evaluated and tested, the auditor should 
distinguish which are IS controls. IS controls--those whose 
effectiveness depends on computer processing--can be classified into 
three types (described in section 295 F):

* general controls,

* application controls, and:

* user controls.

Testing of technical IS controls should be performed by an IS auditor 
as described in section 360. The audit team may assist the IS auditor 
by testing user controls and application controls involving manual 
follow-up.

.05: 
In the planning phase, the auditor and the IS auditor should understand 
each of the three types of IS controls to the extent necessary to 
tentatively conclude whether IS controls are likely to be effective. If 
they are likely to be effective, the auditor should consider specific 
IS controls in determining whether control objectives are achieved (in 
the internal control phase).

.06: 
If IS controls are not likely to be effective, the auditor (with the 
assistance of the IS auditor) should obtain a sufficient understanding 
of control risks arising from IS to develop appropriate findings and to 
plan substantive testing. Also, in the internal control phase, the 
auditor generally should focus on the effectiveness of manual controls 
in achieving control objectives. If IS controls are not likely to be 
effective due to poor general controls and if manual controls do not 
achieve the control objectives, the auditor should identify and 
evaluate, but not test, any specific IS controls that are designed to 
achieve the control objectives (to provide recommendations to improve 
internal control).

.07: 
In the planning phase, the auditor and the IS auditor generally limit 
the understanding of general controls to those at an overall entity 
level. However, obtaining this understanding generally requires visits 
to selected installations. General controls related to an installation 
level and to specific applications will be considered in more detail in 
the internal control phase. In assessing general controls, the auditor 
and the IS auditor should consider the results of past internal and 
external reviews.

.08: 
The auditor should keep in mind that, as stated in SAS 94, paragraph 
66, in some circumstances, such as where a significant amount of 
information is electronically initiated, recorded, processed, and 
reported, it may not be practical or possible to restrict detection 
risk to an acceptable level by performing only substantive tests for 
one or more financial statement assertions. In such circumstances, the 
auditor should test IS controls to obtain evidential matter about the 
effectiveness of both the design and operation of controls to reduce 
the assessed level of control risk.

[End of section]

Planning Phase: 

275 - IDENTITY RELEVANT OPERATIONS CONTROLS TO EVAULATE AND TEST: 

.01: 
The overall intent of the CFO Act is to improve the quality of federal 
financial management. Reliable financial information and effective 
internal control are important to the quality of such federal financial 
management. In a financial statement audit, the auditor draws a 
conclusion about the effectiveness of certain financial reporting 
(including safeguarding and budget) and compliance (including budget) 
controls. For operations controls, the auditor:

* may evaluate certain operations controls considered relevant (see 
paragraphs 275.02-.07),

* should evaluate and test operations controls that are relied on in 
performing audit procedures (see paragraph 275.08), and:

* should understand the components of internal control relating to the 
existence and completeness (and valuation is required for GAO audits) 
assertions relevant to the performance measures reported in the MD&A, 
in order to report on those controls that have not been properly 
designed and placed in operation, but does not need to test those 
controls, although he or she may decide to do so (see paragraph 
275.09).

RELEVANT OPERATIONS CONTROLS:

.02: 
For the potential operations control needs of the entity or for 
operations control weaknesses identified through the procedures 
described in paragraphs 275.04-.07, the auditor should determine 
whether the evaluation of related controls should (1) be included in 
the financial audit, (2) become a separate audit, or (3) not be 
performed but any weaknesses be reported to the IG. In making this 
determination, the auditor might consider the following factors:

* the significance of the operations control to the entity's 
operations,

* the time required to identify and test the operations control,

* available resources, and:

* congressional interest.

.03: 
Audit team management should agree on the operations controls that are 
to be evaluated and tested as part of the financial audit. Such 
operations controls should be documented in the workpapers. For 
example, audit management may require that before evaluating and 
testing a specific operations control, the audit team submit relevant 
information to audit management on a standard form developed by the 
audit team.

.04: 
In the planning phase and throughout the audit, the auditor generally 
should identify significant areas where the entity would be expected to 
have operations controls. The auditor may become aware of these areas, 
as well as potential weaknesses in operations controls, through:

* understanding the entity's operations.

* planning the audit procedures,

* understanding audit risks and weaknesses in financial reporting and 
compliance controls,

* understanding the cause of misstatements noted, or:

* observations made during on-site fieldwork.

.05: 
In obtaining an understanding of the entity's operations, the auditor 
should identify those areas that are critical to such operations. For 
each of these areas, the entity should have effective operations 
controls. Also, in planning the audit, the auditor may identify 
operations controls that could be evaluated in conjunction with planned 
audit and other procedures. For example, the auditor may evaluate 
whether management considered appropriate order quantities for each 
inventory purchase selected in a test of inventory purchases.

.06: 
The auditor identifies specific risks and weaknesses in planning and 
performing the audit and in determining the causes of misstatements 
requiring audit adjustments. The auditor should consider the 
implications of those risks and weaknesses on the entity's operations 
controls. For example, misstatements in inventory records may indicate 
weaknesses in operations controls whose effectiveness depends on 
accurate inventory records. This would include the operations controls 
for maintaining proper inventory levels.

.07: The auditor should be alert to any opportunities to recommend 
improvements to operations controls. Such opportunities could come to 
light while visiting the entity's various locations and performing the 
financial audit.

OPERATIONS CONTROLS RELIED ON IN THE AUDIT:

.08: 
If any contemplated audit procedure relies on operations controls, the 
auditor should identify and test such controls. For example, assume 
that an auditor is using substantive analytical procedures, based on 
entity-generated "per unit" statistics, to test the reasonableness of 
certain operating costs. The auditor plans to compare such "per unit" 
statistics with published costs incurred by similar operations. The 
auditor will need to identify and test the entity's operations controls 
over the production of these internal statistics.

OPERATIONS CONTROLS OVER REPORTED PERFORMANCE MEASURES:

.09: 
OMB audit guidance requires the auditor to understand the design of 
internal controls over the existence and completeness (see definition 
in paragraph 235.02) assertions (and GAO has added valuation as a 
requirement for its audits) related to the performance measures the 
entity reports on in the MD&A and whether they have been placed in 
operation. However, OMB does not require the auditor to test the 
controls (determine operating effectiveness), although he or she may 
decide to do so. The procedures the auditor performs to gain the 
understanding do not need to be extensive but may consist of 
discussions, observations, and walkthroughs (see AU 319.41-.43).

[End of section]

Planning Phase: 

280 - PLAN OTHER AUDIT PROCEDURES:

.01: The auditor should consider the following areas during the 
planning phase, even though many related audit procedures will be 
applied during the other phases.

INQUIRIES OF LEGAL COUNSEL:

.02: As discussed in AU 337 and section 550, the auditor should make 
inquiries of the entity's counsel and perform other audit procedures 
regarding litigation, claims, and assessments. Because of the amount of 
the time needed by management and the legal counsel to gather and 
report the necessary information (including the potential need for 
management to inquire of Department of Justice legal counsel on a case-
specific basis), the auditor should plan the following procedures 
(which are described in more detail in AU 337) for an appropriate time 
in the audit:

* making inquiries of management regarding their policies and 
procedures used for identifying, evaluating, and accounting for 
litigation, claims, and assessment;

* obtaining a description and evaluation of all such matters existing 
as of the balance sheet date and through the date of management's 
response (which should be near the end of fieldwork);

* obtaining evidence regarding legal counsel used by the entity and 
matters handled; and:

* sending letters of audit inquiry to legal counsel (the auditor may 
limit the inquiry to matters that are considered individually or 
collectively material to the financial statements, provided the entity 
and the auditor have reached an understanding and agreement on the 
materiality level).

MANAGEMENT REPRESENTATIONS:

.03: As discussed in section 550, the auditor is required to obtain a 
representation letter from management on specific matters prior to 
completion of the audit. Particularly during first year audits and when 
standards change, the auditor may want to discuss these required 
representations with management early in the audit to identify and 
resolve any difficulties related to obtaining these representations. 
Note that for federal government auditors, these representations 
include (1) the effectiveness of internal control, (2) compliance with 
laws and regulations, and, (3) for CFO Act agencies, financial 
management systems' substantial compliance with FFMIA requirements. 
Additional guidance on management representations is provided in AU 
333, AU 801, AT 101, AT 201, AT 501, AT 601, and section 1001 (Part 
II). Also, a summary of uncorrected misstatements aggregated by the 
auditor is to be included or attached to the letter, which should state 
management's belief that the effects of the misstatements are 
immaterial to the financial statements taken as a whole, both 
individually and in the aggregate. (See section 595 D for an example 
summary of uncorrected misstatements.)

RELATED PARTY TRANSACTIONS:

.04: AU 334 and sections 550 and 902 provide guidance on audit 
procedures that should be performed to identify related parties and 
related party transactions as well as examining these transactions for 
appropriate disclosure in the financial statements. During the planning 
phase, the auditor should perform procedures to identify and document 
related parties and the nature of related party transactions that might 
need to be disclosed in the financial statements and related notes. 
Such information should be distributed to all members of the audit team 
for use in summarizing and testing related party transactions and 
identifying any additional related parties.

SENSITIVE PAYMENTS:

.05: In the planning phase, the auditor should consider the audit 
procedures that will be applied to sensitive payments. Sensitive 
payments encompass a wide range of functions, including executive 
compensation, travel, official entertainment funds, unvouchered 
expenditures, consulting services, speaking honoraria and gifts, and 
executive perquisites. See GAO's Guide for Evaluating and Testing 
Controls Over Sensitive Payments, GAO/AFMD-8.1.2, Washington, D.C.: May 
1993.

REACHING AN UNDERSTANDING WITH OFFICIALS OF THE ENTITY AND REQUESTERS:

.06: During planning, the auditor should reach an understanding with 
officials of the entity, including management and individuals 
contracting for or requesting the audit, about the work to be 
performed, as required by AU 310 and GAGAS (chapter 4). If the audit is 
done based on the request of a committee or member of Congress, the 
auditor should communicate with that committee or member as well as 
management. If the audit is required by law or is self-initiated, the 
auditor should communicate with the committee members or staff who have 
oversight of the auditee as well as management.

.07: The auditor should communicate with officials of the entity and 
the committee or member in writing (preferred) or orally and document 
the understanding reached. "Commitment" letters may be used to 
communicate with Congress about the auditor's planned work. In drafting 
commitment letters, the auditor should consider the matters required to 
be communicated by the auditing standards. If the audit organization 
has a general ongoing working relationship with Congress and prior 
audit reports, there may already be an understanding with the 
applicable committee or other requester.

.08: Because of an ongoing working relationship with either a requester 
or management, the auditor may affirm the contents of the prior audit 
report, since the types of information included in the understanding 
are generally included in the objectives, scope, and methodology 
section of the audit report.

.09: Examples of the matters that are generally included in the 
understanding are the objectives and limitations of the audit and 
management's and the auditor's responsibilities. These are described in 
AU 310. GAGAS also require the understanding to relate to the auditor's 
responsibility for testing and reporting on compliance and internal 
control.

OTHER AUDIT REQUIREMENTS:

.10: Under GAGAS, chapter 4, the auditor should consider the results of 
previous audits and attestation engagements and follow up on known 
significant findings and recommendations that relate directly to the 
objectives of the current audit. Generally, a financial audit should 
cover areas that had findings and recommendations in previous audits. 
However, the auditor should consider whether any findings and 
recommendations from the prior year financial audit need follow-up that 
would not otherwise be covered (for example, findings at locations that 
would not otherwise be revisited).

.11: During planning, the auditor also should consider the additional 
requirements in OMB audit guidance for legal letters, management 
representation letters, and certain agreed-upon procedures. OMB audit 
guidance has specific dates by which interim and updated legal letters 
for CFO Act agencies and covered executive agencies subject to the 
Accountability of Tax Dollars Act of 2002 [Footnote 1] are to be 
requested and received, specific formats for summarizing the 
information in the letters, and a list of specific officials to whom 
copies of the letters and summaries should be forwarded. The guidance 
also has an example of a management representation letter. In addition, 
the guidance requires that certain agreed-upon procedures be applied to 
agency payroll offices and requires that reports be submitted to OPM by 
a specific date.

FOOTNOTES: 

[1] OMB issued guidance implementing the act by applying its guidance 
for CFO Act agencies to covered executive agencies.

[End of section]

Planning Phase: 

285 - PLAN LOCATIONS TO VISIT: 

.01: 
Most federal entities conduct operations, perform accounting functions, 
and/or retain records at multiple locations. During planning, the 
auditor needs to consider the effect of these multiple locations on the 
audit approach. The auditor should develop an understanding of the 
respective locations, including significant accounts and accounting 
systems and cycles/applications. This understanding may be obtained 
centrally or in combination with visits to field offices, as 
appropriate. When planning locations to visit, the auditor should 
consider whether certain locations warrant more extensive testing than 
others, based on the following factors:

* Materiality or significance of locations to the overall entity: More 
material locations, particularly those individually exceeding design 
materiality, and significant cycles/accounting applications may 
require more extensive testing.

* The results of the preliminary analytical procedures applied during 
planning: Unusual results require follow-up, possibly including on-site 
testing at specific locations causing such results.

* The results and the extent of audit procedures applied in prior years 
by the auditor or others, including the time since significant 
procedures were performed: Problems