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[This page intentionally left blank.] GAO/PCIE Financial Audit Manual: (including April 2003 update): This page was last revised April 28 ,2003: Volume 1 - Methodology [PDF 1.5mb] Cover to Volume 1 [PDF 8.3mb] Section 100 - Foreword, Table of Contents, Introduction: Section 200 - Planning: Section 300 - Internal Control: Section 400 - Testing: Section 500 - Reporting: Section Appendixes - Appendixes, Glossary, Abbreviations, Index: Volume 2 - Tools [PDF 3.0mb] Cover to Volume 2 [PDF 8.3mb] Section 600 - Planning and General: Section 700 - Internal Control: Section 800 - Compliance: Section 900 - Substantive Testing: Section 1000, except for CFO Act Checklist - Reporting: CFO Act Checklist, Beginning - Overview, General Items, Balance Sheet: CFO Act Checklist, End - Statements of Net Cost, Changes in Net Position, Budgetary Resources, Financing, Custodial Activity, Notes, and Supplementary Information: Other Related Guidance: GAO's FFMIA Reporting: Download zipped files that allow users to enter data: Sections 300, 400, and 500 - SCE (FAM 395 H - both transaction-related and line item-related), ARA (FAM 395 I), sampling documentation (FAM 495 E), example audit report and summaries of misstatements (FAM 595 A, B, C, and D): Sections 600 and 700 - example documentation and templates for using the work of others (FAM 650 B and C), agreed-upon procedures (FAM 660 A, B, C, and D), and testing compliance with FFMIA (FAM 701 A and B): Section 800 - general compliance checklist (FAM 802) and summary and audit procedures for other acts (FAM 803, 808, 809, 810, 812, 813, 814, 816, and 817): Sections 900 and 1000, except CFO Act checklist - example documentation and templates for related parties, including intragovernmental activity and balances (FAM 902 C), Fund Balance with Treasury (FAM 921 D), management representations (FAM 1001 A), inquiries of legal counsel (FAM 1002 A, B, C, and D), audit completion checklist (FAM 1003), and subsequent events review (FAM 1005): CFO Act checklist (FAM 1004): Financial Audit Manual: Foreword: On behalf of the General Accounting Office (GAO) and the President's Council on Integrity and Efficiency (PCIE), we are pleased to present the first-ever GAO/PCIE Financial Audit Manual. With passage of the Government Management and Reform Act of 1994, executive branch Inspectors General and GAO gained statutory responsibility for auditing agency and government-wide consolidated financial statements, respectively. Since that time, GAO and the PCIE community have worked cooperatively to ensure that these audits are of the highest possible quality, consistency, and cost-effectiveness. This manual is a natural outgrowth of that cooperation. More importantly, the new manual represents our ongoing efforts to ensure that financial statement audits achieve their intended outcomes of providing enhanced accountability over taxpayer-provided resources. We extend our thanks to the many individuals and organizations that provided comments and insights to make the manual stronger. The Task Force assembled by GAO and the PCIE also deserves much credit for its dedication to completing this project. Jeffrey C. Steinhoff Managing Director U.S. General Accounting Office The Honorable Gregory H. Friedman: Chair, Audit Committee: President's Council on Integrity and Efficiency: Signed by Jeffrey C. Steinhoff and Gregory H. Friedman: [End of section] CONTENTS: : 100; INTRODUCTION. 200; PLANNING PHASE. 210; Overview. 220; Understand the Entity's Operations. 225; Perform Preliminary Analytical Procedures. 230; Determine Planning, Design, and Test Materiality. 235; Identify Significant Line Items, Accounts, Assertions, and RSSI. 240; Identify Significant Cycles, Accounting Applications, and Financial Management Systems. 245; Identify Significant Provisions of Laws and Regulations. 250; Identify Relevant Budget Restrictions. 260; Identify Risk Factors. 270; Determine Likelihood of Effective Information System Controls. 275; Identify Relevant Operations Controls to Evaluate and Test. 280; Plan Other Audit Procedures. * Inquiries of Attorneys. * Management Representations. * Related Party Transactions. * Sensitive Payments. * Reaching an Understanding with Management and Requesters. * Other Audit Requirements. 285; Plan Locations to Visit. 290; Documentation. * Appendixes to Section 200: 295 A; Potential Inherent Risk Conditions. 295 B; Potential Control Environment, Risk Assessment, Communication, and Monitoring Weaknesses. 295 C; An Approach for Multiple-Location Audits. 295 D; Interim Substantive Testing of Balance Sheet Accounts. 295 E; Effect of Risk on Extent of Audit Procedures. 295 F; Types of Information System Controls. 295 G; Budget Controls. 295 H; Laws Identified in OMB Audit Guidance and Other General Laws. 295 I; Examples of Auditor Responses to Fraud Risk Factors. 295 J; Steps in Assessing Information System Controls. 300; INTERNAL CONTROL PHASE. 310; Overview. 320; Understand Information Systems. 330; Identify Control Objectives. 340; Identify and Understand Relevant Control Activities. 350; Determine the Nature, Timing, and Extent of Control Tests and of Tests for Systems' Compliance with FFMIA Requirements. 360; Perform Nonsampling Control Tests and Tests for Systems' Compliance with FFMIA Requirements. 370; Assess Controls on a Preliminary Basis. 380; Other Considerations. 390; Documentation. Appendixes to Section 300: 395 A; Typical Relationships of Accounting Applications to Line Items/ Accounts. 395 B; Financial Statement Assertions and Potential Misstatements. 395 C; Typical Control Activities. 395 D; Selected Statutes Relevant to Budget Execution. 395 E; Budget Execution Process. 395 F; Budget Control Objectives. 395 F Sup; Budget Control Objectives - Federal Credit Reform Act Supplement. 395 G; Rotation Testing of Controls. 395 H; Specific Control Evaluation Worksheet. 395 I; Account Risk Analysis Form. 400; TESTING PHASE. 410; Overview. 420; Consider the Nature, Timing, and Extent of Tests. 430; Design Efficient Tests. 440; Perform Tests and Evaluate Results. 450; Sampling Control Tests. 460; Compliance Tests. 470; Substantive Tests - Overview. 475; Substantive Analytical Procedures. 480; Substantive Detail Tests. 490; Documentation. Appendixes to Section 400: 495 A; Determining Whether Substantive Analytical Procedures Will Be Efficient and Effective. 495 B; Example Procedures for Tests of Budget Information. 495 C; Guidance for Interim Testing. 495 D; Example of Audit Matrix with Statistical Risk Factors. 495 E; Sampling. 495 F; Manually Selecting a Dollar Unit Sampling. 500; REPORTING PHASE. 510; Overview. 520; Perform Overall Analytical Procedures. 530; Determine Adequacy of Audit Procedures and Audit Scope. 540; Evaluate Misstatements. 550; Conclude Other Audit Procedures. * Inquiries of Attorneys. * Subsequent Events. * Management Representations. * Related Party Transactions. 560; Determine Conformity with Generally Accepted Accounting Principles. 570; Determine Compliance with GAO/PCIE Financial Audit Manual. 580; Draft Reports. * Financial Statements. * Internal Control. * Financial Management Systems. * Compliance with Laws and Regulations. * Other Information in the Accountability Report. 590; Documentation. Appendixes to Section 500: 595 A; Example Auditor's Report - Unqualified. 595 B; Suggested Modifications to Auditor's Report. 595 C; Example Summary of Possible Adjustments. 595 D; Example Summary of Unadjusted Misstatements. APPENDIXES. A; Consultations. B; Instances Where the Auditor "Must" Comply with the FAM. GLOSSARY. ABBREVIATIONS. INDEX. [End of table] SECTION 100: Introduction: Table 1: Methodology Overview: Figure 100.1: Methodology Overview: Planning Phase: Understand the entity's operations: Section: 220: Perform preliminary analytical procedures: Section: 225: Determine planning, design, and test materiality: Section: 230: Identify significant line items, accounts, assertions, and RSSI: Section: 235: Identify significant cycles, accounting applications, and financial management systems: Section: 240: Identify significant provisions of laws and regulations: Section: 245: Identify relevant budget restrictions: Section: 250: Assess risk factors: Section: 260: Determine likelihood of effective information system controls: Section: 270: Identify relevant operations controls to evaluate and test: Section: 275: Plan other audit procedures: Section: 280: Plan locations to visit: Section: 285: Internal Control Phase: Understand information systems: Section: 320: Identify control objectives: Section: 330: Identify and understand relevant control activities: Section: 340: Determine the nature, timing, and extent of control tests and of tests for systems' compliance with FFMIA requirements: Section: 350: Perform nonsampling control tests and tests for systems' compliance with FFMIA requirements: Section: 360: Assess controls on a preliminary basis: Section: 370: Testing Phase: Consider the nature, timing, and extent of tests: Section: 420: Design efficient tests: Section: 430: Perform tests and evaluate results: Section: 440: Sampling control tests: Section: 450: Compliance tests: Section: 460: Substantive tests: Section: 470: Substantive analytical procedures: Section: 475: Substantive detail tests: Section: 480: Reporting Phase: Perform overall analytical procedures: Section: 520: Determine adequacy of audit procedures and audit scope: Section: 530: Evaluate misstatements: Section: 540: Conclude other audit procedures: Section: 550: Inquire of attorneys: Consider subsequent events: Obtain management representations: Consider related party transactions: Determine conformity with generally accepted accounting principles: Section: 560: Determine compliance with GAO/PCIE Financial Audit Manual: Section: 570: Draft reports: Section: 580: [End of table] .01: This introduction provides an overview of the methodology of the General Accounting Office (GAO) and the President's Council on Integrity and Efficiency (PCIE) for performing financial statement audits of federal entities, describes how the methodology relates to relevant auditing and attestation standards and Office of Management and Budget (OMB) guidance, and outlines key issues to be considered in using the methodology. OVERVIEW OF THE METHODOLOGY: .02 The overall purposes of performing financial statement audits of federal entities include providing decisionmakers (financial statement users) with assurance as to whether the financial statements are reliable, internal control is effective, and laws and regulations are complied with. To achieve these purposes, the approach to federal financial statement audits involves four phases: * Plan the audit to obtain relevant information in the most efficient manner. * Evaluate the effectiveness of the entity's internal control and, for Chief Financial Officers (CFO) Act Agencies and components designated by OMB, whether financial management systems substantially comply with the requirements of the Federal Financial Management Improvement Act of 1996 (FFMIA): federal financial management systems requirements, applicable federal accounting standards,[Footnote 1] and the U.S. Government Standard General Ledger (SGL) at the transaction level.[Footnote 2] * Test the significant assertions related to the financial statements and test compliance with laws and regulations. * Report the results of audit procedures performed. These phases are illustrated in figure 100.1 and are summarized below. [Footnote 3] Planning Phase: .03: Although planning continues throughout the audit, the objectives of this initial phase are to identify significant areas and to design efficient audit procedures. To accomplish this, the methodology includes guidance to help in * understanding the entity's operations, including its organization, management style, and internal and external factors influencing the operating environment; * identifying significant accounts, accounting applications, and financial management systems; important budget restrictions, significant provisions of laws and regulations; and relevant controls over the entity's operations; determining the likelihood of effective information systems (IS) controls; performing a preliminary risk assessment to identify high-risk areas, including considering the risk of fraud; and: planning entity field locations to visit. Internal Control Phase: .04: This phase entails evaluating and testing internal control to support the auditor's conclusions about the achievement of the following internal control objectives: Reliability of financial reporting--transactions are properly recorded, processed, and summarized to permit the preparation of the principal statements and required supplementary stewardship information (RSSI) in accordance with generally accepted accounting principles (GAAP), and assets are safeguarded against loss from unauthorized acquisition, use, or disposition. 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 principal statements or RSSI and (b) any other laws, regulations, and governmentwide policies identified by OMB in its audit guidance. OMB audit guidance requires the auditor to test controls that have been properly designed to achieve these objectives and placed in operation, to support a low assessed level of control risk. This may be enough testing to give an opinion on internal control. GAO audits should be designed to give an opinion on internal control.[Footnote 4] If the auditor does not give an opinion, generally accepted government auditing standards (GAGAS) require the report to state whether tests were sufficient to give an opinion. .05: OMB's audit guidance includes a third objective of internal control, related to performance measures. The auditor is required to understand the components of internal control relating to the existence and completeness assertions and to report on internal controls that have not been properly designed and placed in operation, rather than to test controls. .06: This manual also provides guidance on evaluating internal controls related to operating objectives that the auditor elects to evaluate. Such controls include those related to safeguarding assets from waste or preparing statistical reports. .07: To evaluate internal control, the auditor identifies and understands the relevant controls and tests their effectiveness. Where controls are considered to be effective, the extent of substantive testing can be reduced. .08: The methodology includes guidance on: * assessing specific levels of control risk, * selecting controls to test, * determining the effectiveness of IS controls, and: * testing controls, including coordinating control tests with the testing phase. .09: Also, during the internal control phase, for CFO Act agencies and their components identified in OMB's audit guidance, the auditor should understand the entity's significant financial management systems and test their compliance with FFMIA requirements. Testing Phase: .10: The objectives of this phase are to (1) obtain reasonable assurance about whether the financial statements are free from material misstatements, (2) determine whether the entity complied with significant provisions of applicable laws and regulations, and (3) assess the effectiveness of internal control through control tests that are coordinated with other tests. .11: To achieve these objectives, the methodology includes guidance on: * designing and performing substantive, compliance, and control tests; * designing and evaluating audit samples; * correlating risk and materiality with the nature, timing, and extent of substantive tests; and: * designing multipurpose tests that use a common sample to test several different controls and specific accounts or transactions. Reporting Phase: .12: This phase completes the audit by reporting useful information about the entity, based on the results of audit procedures performed in the preceding phases. This involves developing the auditor's report on the entity's (1) financial statements (also called Principal Statements) and other information (management's discussion and analysis [MD&A] or the overview, RSSI, other required supplementary information, and other accompanying information), (2) internal control, (3) whether the financial management systems substantially comply with FFMIA requirements, and (4) compliance with laws and regulations. To assist in this process, the methodology includes guidance on forming opinions on the principal statements and conclusions on internal control, as well as how to determine which findings should be reported. Also included is an example report designed to be understandable to the reader. RELATIONSHIP TO APPLICABLE STANDARDS: .13: The following section describes the relationship of this audit methodology to applicable auditing standards, OMB guidance, and other policy requirements. It is organized into three areas: * relevant auditing standards and OMB guidance, * audit requirements beyond the "yellow book," and: * auditing standards and other policies not addressed in this manual. Relevant Auditing Standards and OMB Guidance: .14: This manual provides a framework for performing financial statement audits in accordance with Government Auditing Standards (also known as generally accepted government auditing standards or GAGAS) issued by the Comptroller General of the United States ("yellow book"); incorporated generally accepted auditing standards (GAAS) and attestation standards established by the American Institute of Certified Public Accountants (AICPA); and OMB's audit guidance. .15: This manual describes an audit methodology that both integrates the requirements of the standards and provides implementation guidance. The methodology is designed to achieve: * effective audits by considering compliance with the CFO Act, FFMIA, GAGAS, and OMB guidance; * efficient audits by focusing audit procedures on areas of higher risk and materiality and by providing an integrated approach designed to gather evidence efficiently; * quality control through an agreed-upon framework that can be followed by all personnel; and: * consistency of application through a documented methodology. .16: The manual supplements GAGAS and OMB's audit guidance. References are made to Statements on Auditing Standards (preceded by the prefix "AU") and Statements on Standards for Attestation Engagements (SSAE) (preceded by the prefix "AT") of the Codification of Statements on Auditing Standards, issued by the AICPA, that are incorporated into GAGAS. Audit Requirements Beyond the "Yellow Book": .17: In addition to meeting GAGAS requirements, audits of federal entities to which OMB's audit guidance applies must be designed to achieve the following objectives described in OMB's audit guidance: * responsibility for performing sufficient tests of internal controls that have been properly designed and placed in operation, to support a low assessed level of control risk; * expansion of the nature of controls that are evaluated and tested to include controls related to RSSI, budget execution, and compliance with laws and regulations; * responsibility to understand the components of internal control relating to the existence and completeness assertions relevant to the performance measures included in the MD&A, in order to report on controls that have not been properly designed and placed in operation; * responsibility to consider the entity's process for complying with 31 U.S.C. 3512 (the Federal Managers' Financial Integrity Act (FMFIA)); * responsibility to perform tests at CFO Act agencies and components identified by OMB to report on the entity's financial management systems' substantial compliance with FFMIA requirements; * responsibility to test for compliance with laws, regulations, and governmentwide policies identified in OMB's audit guidance at CFO Act agencies (regardless of their materiality to the audit); and: * responsibility to consider conformity of the MD&A, RSSI, required supplementary information, and other accompanying information with FASAB requirements and OMB guidance. .18: To help achieve the goals of the CFO Act, GAO audits should be designed to achieve the following objectives,[Footnote 5] in addition to those described in OMB's audit guidance: * Provide an opinion on internal control. * Determine the effects of misstatements and internal control weaknesses on (1) the achievement of operations control objectives, (2) the accuracy of reports prepared by the entity, and (3) the formulation of the budget. * Determine whether specific control activities are properly designed and placed in operation, even if a poor control environment precludes their effectiveness. * Understand the components of internal control relating to the valuation assertion relevant to performance measures reported in the MD&A in order to report on controls that have not been properly designed and placed in operation. Auditing Standards and Other Policies Not Addressed in the Manual: .19: This manual was designed to supplement financial audit and other policies and procedures adopted by GAO and Inspectors General (IGs). As such, it was not intended to address in detail all requirements. For example, report processing is not addressed. .20: Updates to this manual that include additional audit guidance and practice aids, such as checklists and audit programs, will be issued from time to time. GAO and a team representing the PCIE audit committee will be responsible for preparing the updates. There will be an exposure process for significant updates. KEY IMPLEMENTATION ISSUES: .21: The auditor should consider the following factors in applying the methodology to a particular entity: * audit objectives, * exercise of professional judgment, * references to positions, * use of IS auditors, * compliance with policies and procedures in the manual, * use of technical terms, and: * reference to GAO/PCIE Financial Audit Manual (FAM). Audit Objectives: .22: While certain federal entities are not subject to OMB audit guidance, financial statement audits of all federal entities should be conducted in accordance with this guidance to the extent applicable to achieve the audit's objectives. The manual generally assumes that the objective of the audit is to render an opinion on the current year financial statements, a report on internal control, and a report on compliance. Where these are not the objectives, the auditor should use judgment in applying the guidance. In some circumstances, the auditor will expect to issue a disclaimer on the current year financial statements (because of scope limitations). In these circumstances, the auditor may develop a multiyear plan to be able to render an opinion when the financial statements are expected to become auditable. Exercise of Professional Judgment: .23: In performing a financial statement audit, the auditor should exercise professional judgment. Consequently, the auditor should tailor the guidance in the manual to respond to situations encountered in an audit. However, the auditor must exercise judgment properly, assuring that, at a minimum, the work meets professional standards. Proper application of professional judgment could result in additional or more extensive audit procedures than described in this manual. .24: In addition, when exercising judgment, the auditor should consider the needs of, and consult in a timely manner with, other auditors who plan to use the work being performed. In turn, the auditor should coordinate with other auditors whose work he or she wishes to use so that the judgments exercised can satisfy the needs of both auditors. For example, auditors of a consolidated entity (such as the US Government or an entire department or agency) are likely to plan to use the work of auditors of subsidiary entities (such as individual departments and agencies or bureaus and components of a department). This coordination can result in more economy, efficiency, and effectiveness of government audits in general and avoid duplication of effort. .25: Many aspects of the audit require technical judgments. The auditor should ensure a person(s) with adequate technical expertise is (are) available, especially in the following areas: * quantifying planning materiality, design materiality, and test materiality and using materiality as one consideration in determining the extent of testing (see section 230); * specifying a minimum level of substantive assurance based on the assessed combined risk, analytical procedures, and detail tests (see sections 470, 480, and 495 D); * documenting whether selections are samples (intended to be representative and projected to populations) or nonsampling selections that are not projectible (see section 480); * using sampling methods, such as dollar-unit sampling, classical variables estimation sampling, or classical probability proportional to size (PPS) sampling, for substantive or multipurpose testing (including nonstatistical sampling) (see section 480); * using sampling for control testing, other than attribute sampling using the tables in section 450 to determine sample size when not performing a multipurpose test; * using sampling for compliance testing of laws and regulations, other than attribute sampling using the tables in section 460 to determine sample size when not performing a multipurpose test; and: * placing complete or partial reliance on analytical procedures, using test materiality to calculate the limit. The limit is the amount of difference between the expected and recorded amounts that can be accepted without further investigation (see section 475). References to Positions: .26: Various sections of this manual make reference to consultation with audit management and/or persons with technical expertise to obtain approval or additional guidance. Key consultations should be documented in the audit workpapers. Each audit organization should document, in the workpapers or its audit policy manual, the specific positions of persons who will perform these functions. An IG using a firm to perform an audit in accordance with this manual should clarify and document the positions of the persons the firm should consult in various circumstances. * The Assistant Director is the top person responsible for the day-to-day conduct of the audit. * The Audit Director is the senior manager responsible for the technical quality of the financial statement audit, reporting to the Assistant Inspector General for Audit or, at GAO, to the Managing Director. * The Reviewer is the senior manager responsible for the quality of the auditor's reports, reporting to the Assistant Inspector General for Audit (or higher position) or, at GAO, is the Managing Director or the second partner. The Reviewer may consult with others. * The Statistician is the person the auditor consults for technical expertise in areas such as audit sampling, audit sample evaluation, and selecting entity field locations to visit. * The Data Extraction Specialist is the person with technical expertise in extracting data from agency records. * The Technical Accounting and Auditing Expert is the senior manager reporting to the Assistant Inspector General for Audit or higher or, at GAO, is the Chief Accountant. The Technical Accounting and Auditing Expert advises on accounting and auditing professional matters and related national issues. The Technical Accounting and Auditing Expert reviews reports on financial statements and reports that contain opinions on financial information. * The Office of General Counsel (OGC) provides assistance to the auditor in (1) identifying provisions of laws and regulations to test, (2) identifying budget restrictions, and (3) identifying and resolving legal issues encountered in the financial statement audit, such as evaluating potential instances of noncompliance. * The Special Investigator Unit investigates specific allegations involving conflict-of-interest and ethics matters, contract and procurement irregularities, official misconduct and abuse, and fraud in federal programs or activities. In the offices of the IGs this is the investigation unit; at GAO, it is Special Investigations. The Special Investigator Unit provides assistance to the auditor by (1) informing the auditor of relevant pending or completed investigations of the entity and (2) investigating possible instances of federal fraud, waste, and abuse. Use of Information Systems Auditors: .27: The audit standards (SAS 94) require that the audit team possess sufficient knowledge of information systems (IS) to determine the effect of IS on the audit, to understand the IS controls, and to design and perform tests of IS controls and substantive tests. This is generally done by having IS auditors as part of the audit team. IS auditors should possess sufficient technical knowledge and experience to understand the relevant concepts discussed in the manual and to apply them to the audit. While the auditor is ultimately responsible for assessing inherent and control risk, assessing the effectiveness of IS controls requires a person with IS audit technical skills. Specialized technical skills generally are needed in situations where, (1) the entity's systems, automated controls, or the manner in which they are used in conducting the entity's business are complex, (2) significant changes have been made to existing systems or new systems implemented, (3) data are extensively shared among systems, (4) the entity participates in electronic commerce, (5) the entity uses emerging technologies, or (6) significant audit evidence is available only in electronic form. Appendix V of GAO's Federal Information System Controls Audit Manual (FISCAM) contains examples of knowledge, skills, and abilities needed by IS auditors. Certain financial auditors also may possess IS audit technical skills. In some cases, the auditor may require outside consultants to provide these skills. Compliance With Policies and Procedures in the Manual: .28: The following terms are used throughout the manual to describe the degree of compliance with the policy or procedure required. * Must: Compliance with this policy or procedure is mandatory unless an exception is approved in writing by the Reviewer, [Footnote 6]such as in certain instances when a disclaimer of opinion is anticipated. * Should: Compliance with this policy or procedure is expected unless there is a reasonable basis for departure from it. Any such departure and the basis for it are to be documented in a memorandum. The Assistant Director should approve this memorandum and copies should be sent to the Audit Director and the Reviewer. Generally Should: Compliance with this policy or procedure is strongly encouraged. Departure from such policy or procedure should be discussed with the Assistant Director or the audit manager. * May: Compliance with this policy or procedure is optional. When the auditor deviates from a policy or procedure that is expressed by use of the term "must" or "should" in the FAM, he or she should consider the needs of, and consult in a timely manner with, other auditors who plan to use the work of the auditor and provide an opportunity for the other auditors to review the documentation explaining these deviation decisions. Use of Technical Terms: .29: The manual uses many existing technical auditing terms and introduces many others. To assist you, a glossary of significant terms is included in this manual. Reference to GAO/PCIE Financial Audit Manual: .30: When cited in workpapers, correspondence, or other communication, the letters "FAM" should precede section or paragraph numbers from this manual. For example, this paragraph should be referred to as FAM 100.30. FOOTNOTES [1] In October 1999 the American Institute of Certified Public Accountants (AICPA) recognized the Federal Accounting Standards Advisory Board (FASAB) as the accounting standards-setting body for federal government entities under Rule 203 of the AICPA's Code of Professional Conduct. Thus, FASAB standards are recognized as generally accepted accounting principles (GAAP) for federal entities. FASAB standards (Statement of Federal Financial Accounting Standards No. 8, paragraph .40) allow government corporations and certain other federal entities to report using GAAP issued by the Financial Accounting Standards Board (FASB). [2] Testing for FFMIA is most efficiently accomplished, for the most part, as part of the work done in understanding agency systems in the Internal Control phase of the audit. [3] The methodology presented is for performance of a financial statement audit. If the auditor is to use the work of another auditor, see FAM section 650 (under revision). [4] AICPA attestation standards allow the auditor to give an opinion on internal control or on management's assertion about the effectiveness of internal control (except that if material weaknesses are present, the opinion must be on internal control, not management's assertion). The example report in this manual assumes the opinion will be on internal control directly. [5] The manual refers specifically to objectives of GAO audits in various sections. Such objectives are optional for other audit organizations. [6] Capitalized positions are described in paragraph 100.25. 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] 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. 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. 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 or transactions that may signal inherent or control risks (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. 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] 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 2] 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. 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. 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. 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. 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 and 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 (SAS 82) 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 financial statements. 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 3] 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 4] * 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: 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 RISK FACTORS: .18: The auditor is concerned with fraud that causes a material misstatement of the financial statements. Fraud is distinguished from error in that the action causing the misstatement in fraud is intentional. Two types of misstatements are relevant in the auditor's consideration of fraud in a financial statement audit--misstatements arising from fraudulent financial reporting and misstatements arising from misappropriation of assets. .19: Misstatements arising from fraudulent financial reporting are intentional misstatements or omissions of amounts or disclosures in financial statements to deceive financial statement users. Misstatements arising from misappropriation of assets involve the theft of an entity's assets causing the financial statements not to be presented in conformity with GAAP. .20: Both types of fraud usually involve a pressure or incentive to commit fraud and a perceived opportunity to do so. Many experts believe that fraud requires that both be present. Fraud may be concealed through falsified documentation. In a financial statement audit, the auditor does not have a responsibility to authenticate documents. Fraud also may involve collusion, which may cause evidence to appear persuasive when it is not. Although fraud is usually concealed, the presence of risk factors or other conditions may alert the auditor to a possibility of fraud. For example, documents may be missing or records out of balance. However, these conditions may be the result of errors rather than fraud. Identification of Fraud Risk Factors: .21: The auditor should specifically consider and document the risk of material misstatement of the financial statements due to fraud and keep the consideration in mind 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 result in specific identification of fraud risk factors that are present and the auditor's response to the factors. Although fraud risk factors do not necessarily indicate the presence of fraud, they have often been found in situations where fraud has occurred. .22: As part of the consideration of fraud risk, in addition to obtaining representations about fraud risk in the management representation letter (see section 1001), the auditor should inquire of management (a) to obtain management's understanding regarding the risk of fraud in the entity and (b) to learn whether management has knowledge of fraud perpetrated on or within the entity. In addition, if the entity has established a program to prevent, deter, and detect fraud, the auditor should ask the fraud prevention program managers whether the program has identified fraud risk factors. .23: Inspectors general often report numerous cases of fraud and have significant experience in this area. The auditor should obtain information about instances of fraud identified by the IG, ask the Special Investigator Unit to summarize how cases of reported fraud were committed, and ask management whether controls have been strengthened, to consider whether there is a risk of material fraud. .24: Fraud risk factors that relate to misstatements arising from fraudulent financial reporting may be grouped in three categories as follows: * Industry conditions. These factors involve the economic and regulatory environment in which the entity operates. * Operating characteristics and financial stability. These factors pertain to the nature and complexity of the entity and its transactions, the entity's financial condition, and its profitability. * Management's characteristics and influence over the control environment. These factors pertain to management's abilities, pressures, style, and attitude relating to internal control and the financial reporting process. The first two of these categories contain factors that are also inherent risk factors mentioned in the earlier paragraphs of this section and the third category contains factors that are also control risk factors as discussed in subsequent paragraphs. Examples of fraud risk factors in each of these three categories in the federal government are included in sections 295 A and B. .25: Fraud risk factors that relate to misstatements arising from misappropriation of assets may be grouped in two categories as follows: * Susceptibility of assets to misappropriation. These factors pertain to the nature of an entity's assets and the degree to which they are subject to theft. * Controls. These factors involve the lack of controls designed to prevent or detect misappropriations of assets. Examples of fraud risk factors in the first of these two categories in the federal government are also included in section 295 A, and examples of the second category are included in section 295 B. .26: It is not necessary for the auditor to search for indications of financial or other stress on employees that might make them likely to commit fraud. However, if the auditor becomes aware of such information, he or she should keep it in mind in considering the risk of material misstatement due to fraud. Other similar information would include disgruntled employees, anticipated layoffs, and known unusual changes in behavior or lifestyle of employees with access to assets susceptible to misappropriation. The Auditor's Response to the Fraud Risk Consideration: .27: The risk of material misstatement due to fraud always exists to some degree. The auditor should decide whether the audit procedures already planned are sufficient to respond to the fraud risk factors found or whether there is a need to modify the planned audit procedures. If audit procedures need to be modified, the auditor should decide whether an overall response is appropriate or whether the response should be specific to a particular account balance, class of transactions, or assertion or whether both an overall and a specific response are called for. If it is not practicable, as part of a financial statement audit, to modify planned audit procedures sufficiently to address the fraud risk, the auditor should consider requesting assistance from the Special Investigator Unit. See section 290 for documentation re* quirements. .28: The auditor may decide that an overall response covering one or more of the following is appropriate: * Professional skepticism. Due professional care requires the exercise of professional skepticism--an attitude that includes a questioning mind and critical assessment of audit evidence. With an increased risk of material misstatement due to fraud, professional skepticism may cause the auditor to examine documentation of a different nature and greater extent in support of material transactions, or to corroborate management representations more extensively. * Assignment of audit personnel. The qualifications and extent of supervision of personnel assigned on an audit generally should be commensurate with the level of fraud risk. * Accounting principles and policies. With a greater risk of material misstatement due to fraud, the auditor may have a greater concern about whether management may apply accounting principles and policies in an inappropriate manner to create a material misstatement of the financial statements and may need to test more extensively. * Controls. If increased fraud risk exists because of risk factors that have control implications, the auditor may have to assess control risk as high. However, understanding controls in this situation may be even more important than otherwise. The auditor generally should understand how controls (or lack thereof) relate to the fraud risk factors, while noting the extent of management's ability to override controls. .29: Also in an overall response, the nature, timing, and extent of procedures related to certain accounts and assertions may be modified as follows: * The nature may be changed to obtain more reliable evidence or further corroboration, such as from independent sources outside the entity. For example, physical observation of certain assets may become more important. * The timing of substantive tests may be closer to or at year end. * The extent of procedures may involve larger sample sizes or more extensive analytical procedures. .30: The auditor may determine that a specific response is required due to the types of risk factors identified and the accounts and assertions that may be affected. Examples of specific responses are in section 295 I. .31: The consideration of fraud risk is a cumulative process that should be ongoing throughout the audit. Fraud risk factors may be identified at any time during the audit. Also, other conditions may be identified during fieldwork that change or support a judgment regarding fraud risk, such as discrepancies in the accounting records, conflicting or missing evidential matter, or problematic or unusual relationships between management and the auditor. Thus the auditor should continue to be aware of the risk of fraud, and at the conclusion of the audit, the auditor should consider whether the accumulated results of audit procedures and other observations affect the consideration of the risk of material misstatement due to fraud. (See section 540.): CONTROL ENVIRONMENT FACTORS: .32: 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). .33: 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: .34: 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. .35: 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: .36: 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. .37: 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: .38: 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. .39: 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. .40: 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: .41: 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. .42: 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: .43: 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). .44: 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.): .45: 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. .46: 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. .47: 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: .48: 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. .49: 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.): .50: 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: .51: 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. [End of section] 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