Using Financial Statement Data in Single Audit Reports
FINANCIAL STATEMENTS
Insight to systematic issues identified through financial statement analysis
Financial statement analysis (or financial analysis) is the process of reviewing and analyzing an entity’s financial statements for decision-making purposes. Generally Accepted Accounting Principles (GAAP) require an entity to prepare financial statements which include, at a minimum, the balance sheet, the income statement, and the statement of cash flows. Stakeholders in the Single Audit process perform financial statement analysis to understand the overall health of the entity and to analyze its financial performance. The process involves reviewing information from the financial statements and using analytical techniques such as variance analysis and financial ratios to assess the financial position of the entity. When an entity that receives Federal financial assistance is in a situation of financial stress, the objectives of the Federal programs may not be met, and the Federal funds may be at risk of misuse.
HHS-OIG is providing methods of analyzing the financial statements as a resource tool for stakeholders. The information contained herein is not a directive for stakeholders to perform the analysis of the financial statements to meet any specific monitoring requirement(s). However, stakeholders may use this information to identify potential problem areas, also known as “red flags,” in the financial statements, which in turn could help identify mismanagement or potential fraud within Federal programs.
The areas listed below are considered best practices and may be indicators of an organization’s ability to provide proper stewardship over Federal programs. Incorporating financial analysis techniques in the system for monitoring Federal funds can help to identify and remedy problem areas quickly and ensure that Federal funds are being used efficiently and for their intended purposes.
- Definition: This ratio measures whether an entity has enough resources to pay its debts over the next 12 months by comparing the entity’s current assets to its current liabilities. The current ratio is calculated by dividing the current assets by the current liabilities.
- Importance: The current ratio is an important measure of liquidity because short-term liabilities are due for payment within the next year. This means that a company has a limited amount of time to raise the funds to pay for these liabilities. The notes to the financial statements may include additional related information such as explanations, mitigating circumstances, and management plans to improve operations.
- Analysis: If an entity’s current liabilities exceed current assets (e.g., the current ratio is below 1), the entity may have problems meeting its short-term obligations. Additionally, if the current ratio is below 1, compare it to the current ratio for the past 2 years to determine whether the ratio is improving or declining. Also, consider whether the entity has additional resources available and/or a plan to improve its financial position.
- Definition: A bank overdraft is reported when a check, transfer, or direct debit is drawn against an account that does not have sufficient funds available to cover the entire obligation. It represents an entity’s short-term liability to a bank and is recorded as a current liability on the balance sheet. Other terms that may be used include cash overdraft, cash shortage, checks in excess of bank balance, and insufficient funds (or nonsufficient funds).
- Importance: An overdraft occurs when the dollar amount of checks or other items presented to the bank for payment exceeds the balance of the account and, therefore, will be reported as a liability on the balance sheet. An overdraft fee may be charged when a withdrawal from a bank account exceeds the available balance. Interest may also be charged on the overdraft (negative account) balance. The overdraft fee and related interest, if any, should be reported as an expense on the income statement. Large and/or recurring overdrafts are an indicator of poor budgeting and possible financial difficulties. Although an overdraft may arise due to a timing mismatch, it can generate costly fees or even a higher interest rate. Reporting an overdraft on a regular basis is an indication that monies obligated toward a particular program may not be used for their intended purposes, which could result in an audit finding of unallowable costs.
- Analysis: If the financial statements identify an overdraft, review the financial statements and notes to determine whether any related fees and/or interest were charged directly or indirectly to Federal programs. If the report does not provide all of the necessary information, consider contacting the auditee for additional information. To determine whether the amount of the overdraft(s) may indicate financial difficulties, the overdraft amount should be compared to the cash balance. If the overdraft is large in comparison to the cash balance, then it could be indicative of an entity’s financial difficulties and possible uncertain outlook as a going concern.
- Definition: Deferred revenue is used to report advance payments or unearned revenue on the recipient’s balance sheet until conditions have been met that are required for the entity to have a right to the funds. Other terms that may be used for deferred revenue in the financial statements are refundable advances or unearned revenue.
- Importance: Deferred revenue may be used to report Federal program funds that are drawn down prior to the related expenses or immediate needs for the program that has received those funds. There are instances when deferred revenue reported in the financial statements represents advance payments from non-Federal sources or is recorded for the entire Federal award rather than for actual drawdowns. The financial statement notes should provide clarity with a description of the basis and source of any deferred revenue.
- Analysis: If the financial statements contain deferred revenue, review the report to identify any additional information included to help determine whether the balance represents Federal drawdowns and identifies the program(s) affected. This information can be found in the supplementary schedules or in the notes to the financial statements. If funds were drawn down for Federal programs, compare the deferred revenue balance to the program’s expenditures for the year to determine whether the balance is reasonable. A best practice measure is that deferred revenue is considered reasonable if the drawdowns do not exceed 1/12 (or 8 percent) of the fiscal year expenditures for that program. However, if the report does not identify deferred revenue at the program level, consider contacting the auditee for additional information, such as a breakdown of the deferred revenue amounts by program.
- Definition: An interfund transfer is an accounting transaction that moves funds from one account to another. It may also result from one fund providing assets or services to another without charging for those services. (In this context, fund accounting is the practice by which funds are maintained in separate fund accounts to provide proper stewardship over the resources entrusted to the entity.)
- Importance: Interfund transfers are subject to certain restrictions imposed by GAAP. If transfers between funds become repetitive, this is an indicator of ineffective management of resources, or that the fund activities are not properly budgeted. If funds are being drawn down from one Federal program and moved to another fund account that has insufficient cash to cover the fund expenditures, and the impacted accounts are unrelated or are not for the intended program purpose, the transfer is considered an interfund transfer. This activity can become a serious issue—and potentially a reportable finding—when unallowable or unrelated costs are being supported by a Federal program.
- Analysis: If the Statement of Net Position identified deferred revenue, review the program information on the governmental funds balance sheet. Determine whether deferred revenue exceeds cash for any Federal program. Review the prior 2 years’ reports to determine whether this is a recurring issue. The notes to the financial statements may provide a breakdown and/or additional information related to the interfund activity and information on the affected program(s). This information could include the source of the interfund transfers, such as a transfer of Federal funds from another program or a service provided by another agency. If there is insufficient information in the notes, follow up with the auditor or auditee as to the nature of the transfer.
- Definition: Net losses occur when an entity’s total expenses and other uses exceed the entity’s total revenues and other sources for the accounting period.
- Importance: A net loss is an indicator that an entity may be experiencing budget issues that can result in inefficient operations or possible uncertainties as to the entity’s outlook as a going concern for that year. Although net losses are not sustainable, they do not always point to insolvency. Net income from past years (net assets) can be used to cover some net losses. However, a loss does indicate that changes need to be made to either increase revenues or decrease costs. Sometimes, losses are the result of nonrecurring transactions or circumstances, such as the disposal or retirement of fixed assets, a catastrophe, or early extinguishment of debt. Additionally, recording depreciation expense can result in a large net loss. Since depreciation expense is a noncash expense (i.e., funds were not disbursed in the current year), it can be excluded from the net loss calculation when analyzing the impact on the entity’s financial operations.
- Analysis: Calculate the entity’s net income loss by subtracting total expenses and other uses from total revenues and other sources. If the resulting number is negative (a net loss), determine whether depreciation was charged as part of the total expenses. Divide the ending net assets (if positive) by the current year loss (minus the depreciation expense) to determine how many years similar net losses could be sustained. Compare the current year net loss to the net income and/or losses in prior years and determine whether it is improving or declining. Determine whether the loss is a result of a nonrecurring situation. Also, consider whether the entity has a plan to improve its operations.
NOTES TO THE FINANCIAL STATEMENTS
Impact on the Financial Analysis
The notes to the financial statements are a required, integral part of an organization’s external financial statements. They are required because not all relevant financial information can be communicated through the amounts reported on the face of the financial statements. The notes to the financial statements help to provide proper perspective for the information reported in the financial statements themselves. In addition to identifying the basis of accounting used for reporting information in the financial statements, the notes also report conditions that may have a negative effect on the financial statements and areas of higher risk in the entity’s operations, such as the following:
- Definition: This is an accounting term used to express the assumption that an entity will continue to operate as normal without threat of liquidation for the foreseeable future. Under GAAP, the standard is defined under AU-C section 570 as a situation that creates substantial doubt about an entity’s ability to continue as a going concern when relevant conditions and events, considered in the aggregate, indicate a probability that the entity will be unable to meet its obligations as they become due within 1 year after the date that the financial statements are issued. Generally accepted auditing standards instruct auditors to consider whether an entity has the ability to continue as a going concern for a period not greater than 1 year following the date that the financial statements were audited.
- Importance: The ability of an auditee to continue operations is critical to ensure that the purpose and goals of the Federal program(s) will be accomplished. Another concern is the potential for an entity under financial pressure to use advanced Federal funds for nonprogram activities.
- Analysis: Review the auditor’s report to determine whether the auditor identified a going concern issue. Document the auditor’s basis for identifying that issue. Review the financial statements and notes for information related to the financial viability of the entity. This review would include current-year data and, if available, information from prior years.
- Definition: AU-C Section 240 defines fraud as “an intentional act by one or more individuals among management, those charged with governance, employees, or third parties, involving the use of deception that results in a misstatement in financial statements that are the subject of an audit.” Fraud against an organization, a government grant, or a Federal program can be committed internally by employees, managers, officers, or owners of the organization. External fraud is perpetrated by customers, vendors, or other parties. Two basic types of fraud are misappropriation of assets by employees and fraudulent financial reporting by management; both types can result in misleading or inaccurate financial information disseminated to stakeholders. The first type of fraud may happen without management knowledge, and the second type may be unknown to employees.
- Importance: Fraud may occur when there is a lack of internal controls. If controls are not in place or can be circumvented, Federal program funds may be at risk. Fraud can have a substantial impact on an organization and its ability to administer Federal programs. Fraud may be reported in any of the three, signed reports within the audit. It may also be discussed in subsequent events, contingent liabilities, or elsewhere in the notes to the financial statement. Generally Accepted Government Auditing Standards issued by the Comptroller General of the United States, paragraph 6.49 requires auditors to identify suspected noncompliance with provisions of laws, regulations, contracts, or grant agreements, and to identify instances of fraud. However, auditors may limit their public reporting to matters that would not compromise ongoing investigations and legal proceedings, and report only information that is already a matter of public record.
AU-C section 240 discusses the role of the auditor where fraud is suspected. If the auditor has identified suspected fraud, the auditor has a responsibility to notify the appropriate level of management in a timely manner. In cases where upper management is involved in fraudulent activity that is material to the financial statements, the auditor should report the matter immediately to the audit committee. In addition, regarding matters involving illegal activity, the auditor may have a responsibility to report the matter outside the entity, such as a regulatory or law enforcement authority. - Analysis: When reviewing the report, stakeholders should consider that some factors contribute to fraud risk such as the lack of segregation of duties, management override of internal controls, lack of supporting documentation, conflicts of interests, and misappropriation of assets (theft). Reviewers should consider mitigating factors by analyzing the control environment and/or the processes put in place by management, the effectiveness of internal controls and program monitoring procedures, and whether there is a whistleblower hotline. Prevention, detection, and investigation are effective strategies in fraud prevention.
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