The New Role for Council Members in the Audit Process
Michael Moreland is managing partner of Moreland & Associates, Inc., a statewide accounting firm specializing in serving public agencies, and can be reached at MMoreland@moreland-assoc.com. Dennis Kneier is a council member for the City of San Marino and a certified public accountant and can be reached at firstname.lastname@example.org.
Beginning in FY 2007-08, auditors of California cities must comply with the requirements of the Statement on Auditing Standards No. 114, “The Auditor’s Communication With Those Charged With Governance.” Statements on Auditing Standards (SASs) are issued by the American Institute of Certified Public Accountants (AICPA) and apply to all industries in connection with a financial statement audit. SAS No. 114 is one of a series of statements intended to improve the auditing process as a result of perceived audit failures in connection with companies such as Enron. The statements are also an attempt to narrow the “expectation gap” between the CPAs’ understanding of the services they provide and the public’s expectation of those services.
Understanding the Distinction Between Governance And Management
SAS No. 114 distinguishes between those charged with governance versus management. Those charged with governance are the people responsible for overseeing the strategic direction of the entity and its obligations related to accountability, including overseeing the financial reporting process. Management includes the people responsible for achieving the objectives of the entity, with the authority to establish policies and make decisions by which those objectives are to be pursued. Management is responsible for the financial statements, including designing, implementing and maintaining effective internal control over financial reporting.
In large companies, such as General Motors, there is a big distinction between those charged with governance and those responsible for management. As defined here, members of the board of directors oversee the strategic direction of the company including the financial reporting process. Appointment to the General Motors board of directors is reserved for individuals who bring specific talents that have been identified as necessary to carry out the board’s responsibilities. In smaller businesses, such as a restaurant or an insurance agency, those charged with governance and management are frequently the same person or small group of people.
In a California city, the city council members are “those charged with governance,” and the city manager and his or her management group are “management.” They are always two separate groups. To be elected to the city council, the candidate must meet residency and age requirements and receive the most votes. While many city council members possess the skills necessary to oversee the financial reporting process, there is no requirement for them or the city council as a group to have that skill set. On the other hand, the city council requires management to have the skills necessary to achieve the goals of the city, including designing, implementing and maintaining effective internal control over financial reporting.
Understanding the Auditing Process
Because governance is a collective responsibility, a subgroup of the city council, such as an audit committee or even an individual, may be charged with specific tasks to help the city council meet its financial reporting oversight responsibilities. Each city council hires a CPA firm to perform the annual audit. If a city council does not have the necessary skills to carry out its oversight responsibilities, the council may hire a second CPA firm to assist them in meeting their SAS No. 114 responsibilities. They cannot use the same CPA firm for both duties.
Although city council members are not required to have the skills necessary to oversee the financial reporting process in order to get elected, the city council nevertheless must have these skills to carry out the responsibilities of those charged with governance. Therefore, the city council’s choices are to hire a second CPA firm to assist them or to identify someone on the council who can be trained to fulfill these responsibilities. Most city councils are likely to choose the latter option.
As indicated previously, the auditor has a responsibility under SAS No. 114 to report to those charged with governance in connection with the annual audit of the city’s financial statements and:
- Communicate the responsibilities of the auditor in relation to the financial statement audit and provide an overview of the scope and timing of the audit;
- Obtain information relevant to the audit from those charged with governance; and
- Provide the city council with timely observations arising from the audit that are relevant to their responsibilities in overseeing the financial reporting process.
- SAS No. 114 focuses primarily on communications from the auditor to those charged with governance. However, effective two-way communication is also very important in assisting:
- The auditor and those charged with governance in understanding matters related to the audit in context and in developing a constructive working relationship;
- The auditor in obtaining information relevant to the audit from those charged with governance; and
- Those charged with governance in fulfilling their responsibility to oversee the financial reporting process, thereby improving their understanding of the city’s financial position and reducing the risks of material misstatement of the financial statements.
If the auditor believes that the two-way communications with the city council are inadequate, he or she may modify the auditor’s opinion on the basis of a scope limitation or even withdraw from the engagement. Neither of these options is acceptable in the public sector.
Therefore, it is important for council members to understand the new requirements of their auditors imposed by SAS No. 114. It is also important for city councils to identify those members with the skills necessary to provide the required two-way communication with their auditors.
League Training Provides Needed Skills
A practical way to gain the skills necessary to meet these responsibilities is to sign up for League-sponsored training that prepares city council members to more effectively oversee the financial reporting process and establish good two-way communications with their auditors. This training will be offered as part of the New Mayors and Council Members Academy, Jan. 16-18, 2008, at the Hyatt Regency in Sacramento (online registration is available at www.cacities.org/events).
The League training addresses such questions as:
- What are the requirements for an annual audit?
- What is included in the annual audit process?
- How does the city council evaluate the results of the annual audit?
- What are the city council’s responsibilities in connection with the annual audit?
- How does the city council carry out its responsibilities in connection with the annual audit process?
- How does the city council oversee the financial reporting process?
- Why can’t the city council’s responsibilities be delegated to management?
- How does the city council evaluate management’s performance in designing, implementing and maintaining effective internal control over financial reporting?
- What types of services provided by the independent auditor may lead to a lack of independence or the appearance of a lack of independence?
These are the same issues the city council will need to discuss with their auditors on an annual basis.
Many city council members may be concerned about how to address these issues because they do not believe they have the necessary background or education. That is why the League training is so important. Serving on a city council has the same responsibilities as serving on the board of directors of a company. It is critical for the city council to identify those members who, with additional training, are capable of addressing all of these issues on behalf of the entire council.
After one or more members of the city council complete the training program, the entire city council will be much more comfortable dealing with their independent auditors. Future changes in the audit process or changes in the responsibilities of the city council can be provided by the city’s independent auditors.