DRAFT
WHICH FINANCIAL REPORTS IN THE PUBLIC SECTOR
SHOULD BE SUBJECT TO EXTERNAL VALIDATION?
By
Dr. Jesse Hughes, CPA, CIA, CGFM
Professor Emeritus of Accounting
Old Dominion University
Norfolk, VA 23664
Email—[email protected]
March 2004
INTRODUCTION
The International Auditing and Assurance Standards Board (IAASB) has been established by the
International Federation of Accountants (IFAC) as the authoritative body to develop
international standards on quality control, auditing, assurance, and related services.1 Included
within the Preface referenced in the footnote below is the structure of the IAASB’s technical
pronouncements.2 An adaptation of this structure is reflected in Appendix A.
In the application of the international standards for assurance engagements, by and large no
distinction is made between the private and public sector. “Public sector” refers to national
governments, regional (state, provincial, territorial) governments, local (city, town) governments
and related governmental entities (agencies, boards, commissions and enterprises). In
circumstances where specific basic principles, essential procedures or guidance contained in an
ISA are not applicable in a public sector environment, or when additional guidance is appropriate
in such an environment, the Public Sector Committee of IFAC so states in a Public Sector
Perspective (PSP) at the end of the International Standard on Auditing (ISA), the International
Standard on Review Engagements (ISRE), or the International Standard on Assurance
Engagements (ISAE). When no PSP is added, the ISA, ISRE, or ISAE is to be applied as written
to engagements in the public sector.
There is a distinction between the private and public sector relative to accounting standards since
International Accounting Standards (IASs) only apply to the private sector. The Public Sector
Committee (PSC) of IFAC has been established as the authoritative body to develop
International Public Sector Accounting Standards (IPSASs). The core set of accrual IPSASs are
drawn primarily from the IASs with the IASs revised by the PSC, where appropriate, for
application to the public sector.3 Additional IPSASs are presently being developed that go
beyond those IASs published for the private sector. An example is the Cash Basis IPSAS that is
effective for annual financial statements covering periods beginning on or after January 1, 2004.4
This paper suggests some guidelines for application of the ISAs, ISREs, and ISAEs approved by
the IAASB to the public sector financial reports prepared in accordance with the IASs and
IPSASs. In addition, other public sector financial reports (i.e., budget and statistical reports) not
presently required by the IPSASs are addressed in the paper.
PUBLIC SECTOR FINANCIAL REPORTS
It is important to distinguish between Government Business Enterprises (GBEs) and other public
sector entities since IPSASs do not apply to GBEs as stated below:
“GBEs are required to comply with IASs issued by the International Accounting
Standards Committee. The Public Sector Committee’s Guideline No. 1 ‘Financial
1
Preface to the International Standards on Quality Control, Auditing, Assurance and Related Services (IFAC, July
2003).
2
Ibid, p. 12. Although related services (primarily agreed-upon procedures and compilations) are included in the
structure, they are not addressed in this paper since no external validation is provided in the auditor’s report.
3
Handbook of International Public Sector Accounting Standards (IFAC, 2003 Edition).
4
Financial Reporting Under the Cash Basis of Accounting, Cash Basis IPSAS (IFAC, January 2003).
2
Reporting by Government Business Enterprises’ notes that IASs are relevant to all
business enterprises, regardless of whether they are in the private or public sector.
Accordingly, Guideline No. 1 recommends that GBEs should present financial statements
that conform, in all material respects, to IASs.”5
A GBE has the following characteristics: has power to contract in their own name, is assigned
financial and operational authority to carry on a business, can sell goods or services to other
entities at a profit or full cost recovery, is not reliant on continuing government funding to be a
going concern, and is controlled by a public sector entity.6
The International Accounting Standards Committee has been renamed the International
Accounting Standards Board and the IASs have been renamed the International Financial
Reporting Standards (IFRSs). In accordance with the IFRSs, a GBE would issue the following
financial statements using the accrual basis of accounting: Balance Sheet, Income Statement,
Statement of Changes in Equity, and Statement of Cash Flows7 as well as a summary of
significant accounting policies and related notes.
Many public sector entities (other than GBEs) will use a cash basis of accounting to account for
government operations at all levels of government since the cash information is more readily
available (and some would argue, more readily understandable). Further, it is simple to
implement and costs are low due to the lower level of accounting skills required. Consequently,
as mentioned earlier, the PSC has issued a Cash Basis IPSAS that requires a Statement of Cash
Receipts and Payments. In addition, the Cash Basis IPSAS encourages entities using the cash
basis of accounting to disclose additional information pertaining to assets, liabilities and
comparisons to budgets in the notes to the required statement.
Some public sector entities have implemented the accrual basis of accounting for application to
government operations or are in the process of implementing the accrual basis. These entities
would apply the accrual IPSASs (1 through 20). IPSAS 1 stipulates the following financial
statements: Statement of Financial Position, Statement of Financial Performance, Statement
of Changes in Net Assets/Equity, and Cash Flow Statement as well as a summary of
significant accounting policies and related notes.
In addition to the IPSAS approved by the PSC, the International Monetary Fund (IMF) has
published the Government Finance Statistics Manual (GFSM)8 which identifies statements
required for statistical reporting purposes. These statistical statements also require reporting on
the accrual basis of accounting and are as follows: Balance Sheet, Statement of Government
Operations, Statement of Sources and Uses of Cash, and Statement of Other Economic
Flows. Although there are some differences between the IPSASs (e.g. historical cost is
encouraged as the benchmark treatment) and the GFSM (e.g. current cost is required), a project
is underway to eliminate these differences to the maximum extent possible.
5
Op. cit., Pg. 29, IPSAS 1—Presentation of Financial Statements.
Ibid, p. 32.
7
IAS 1—Presentation of Financial Statements, Handbook of International Accounting Standards (IASB, 2003
Edition).
8
Government Finance Statistics Manual (IMF, 2001).
6
3
In addition to the financial statements required by the IPSASs and the statistical statements
required by the IMF, most governments will issue budget reports. Many would consider these
budget reports as the most important financial statements issued by governments since they are
usually published and frequently commented upon in the mass media. In many cases, these
budget reports are on the cash basis of accounting and would include the legally adopted,
annual or biennial budgets and the 3 to 5 year prospective budgetary reports. These budget
reports are referred to as ex-ante budget reports and are published for transparency purposes to
inform the electorate about the financial plans and policies for government operations. Although
these budget reports are not required, preparation and publication is highly recommended by the
IMF and the World Bank.9
In addition to the ex-ante budget reports, most governments will prepare budget to actual
comparative statements at the end of the accounting period. These are referred to as ex-post
budget reports to inform the electorate about the degree of adherence to the budget for
accountability purposes. Although this comparative report is not required, preparation and
publication is encouraged by the PSC10, as well as the IMF and the World Bank referenced
earlier. If the budget is on one basis (i.e. cash) and accounting is on another basis (i.e. accrual), a
reconciling statement is generally prepared to identify the differences between the two systems.
ASSURANCE ENGAGEMENTS
To implement the structure of technical pronouncements, the IAASB has established an
International Framework for Assurance Engagements. Critical definitions from that
framework are included below:11
Assurance engagement—an engagement in which a practitioner expresses a conclusion
designed to enhance the degree of confidence of the intended users other than the
responsible party about the outcome of the evaluation or measurement of a subject matter
against criteria (p. 4). The elements of an assurance engagement are as follows: a three
party relationship involving a practitioner, a responsible party, and intended users;
appropriate subject matter; suitable criteria (may include International Financial
Reporting Standards or International Public Sector Accounting Standards—p. 12);
sufficient appropriate evidence; and a written assurance report in the form appropriate to
a reasonable assurance engagement or a limited assurance engagement (p. 8).
Reasonable assurance—reduction in risk to an acceptably low level in the
circumstances of the engagement as the basis for a positive form of expression of the
practitioner’s conclusion (p. 5). For reasonable assurance engagements regarding
historical financial information, these engagements are called audits (Footnote 2, p. 3).
9
Public Expenditure Management Handbook (The World Bank, 1998) and the Code of Good Practices on Fiscal
Transparency (IMF, 2003).
10
Para. 22, IPSAS 1 (IFAC, May 2000) and Para. 2.1.36, Cash Basis IPSAS (IFAC, January 2003).
11
International Framework for Assurance Engagements (IFAC, December 2003).
4
Limited assurance—reduction in risk to a level that is acceptable in the circumstances of
the engagement, but where that risk is greater than a reasonable assurance engagement, as
the basis for a negative form of expression of the practitioner’s conclusion (p. 5). For
limited assurance engagements regarding historical financial information, these
engagements are called reviews (Footnote 2, p. 3).
In a reasonable assurance engagement (including an audit of historical financial information), the
practitioner must accumulate enough evidence to be in a position to express a conclusion in the
positive form. An example of the positive form follows: “In our opinion the financial statements
are fairly stated, in all material respects, based on (the criteria used)”. Gathering sufficient
appropriate evidence is part of an iterative, systematic process that involves obtaining an
understanding of internal control and determining the degree of compliance with laws and
regulations as well as evaluating the sufficiency and appropriateness of the evidence. Procedures
used would include inspections, observations, confirmations, analytical procedures and inquiries.
Where applicable, substantive procedures would be used to obtain corroborating information
from sources independent of the responsible party. In addition, for most subject matters, tests of
the operating effectiveness of internal controls would be performed.
In a limited assurance engagement (including a review of historical financial information), the
practitioner must accumulate enough evidence to be in a position to express a conclusion in the
negative form. An example of the negative form follows: “Based on our work described in this
report, nothing has come to our attention that causes us to believe that the financial statements
are not fairly stated, in all material respects, based on (the criteria used)”. Sufficient appropriate
evidence for reviews of financial statements is obtained primarily through analytical procedures
and inquiries.
An unqualified conclusion is not appropriate for either type of assurance engagement if there is a
material limitation on the scope of the practitioner’s work or if a material deficiency is revealed.
In these instances, a qualified or adverse opinion would be more appropriate or a disclaimer of
an opinion might be warranted.
As identified in the Structure of the IAASB’s Technical Pronouncements (see Appendix A), the
international framework for assurance engagements is composed of the following: 1. Audits and
reviews of historical financial information and 2. Assurance engagements other than audits or
reviews of historical financial information. ISAs 200-799 will apply to audits and be compiled
from current ISAs 210-799. ISREs 2000-2699 will apply to international standards for review
engagements and be compiled from current ISA 910. A project is underway to more clearly
define the coverage in Special Purpose Audit Engagements (ISA 800). The current ISA 800
discusses the following reports:12
1. Reports on Financial Statements Prepared in Accordance with a Comprehensive Basis of
Accounting other than International Accounting Standards or National Standards. (The
cash receipts and disbursements basis of accounting as well as the financial reporting
provisions of a government regulatory agency are identified as examples for these
financial statements);
12
Pp. 551-566, ISA 800, The Auditor’s Report on Special Purpose Audit Engagements (IFAC Handbook of
International Auditing, Assurance, and Ethics Pronouncements; 2004 Edition).
5
2. Reports on a Component of Financial Statements;
3. Reports on Compliance with Contractual Agreements; and
4. Reports on Summarized Financial Statements.
The Structure further specifies Assurance Engagements on Subject Matters Other than Historical
Financial Information. An international standard has been issued to apply to such assurance
reports dated on or after January 1, 2005.13 One aspect of these assurance engagements pertains
to the examination of prospective financial information as spelled out in ISAE 3400.14 When
reporting on the reasonableness of management’s assumptions, the auditor provides only a
limited level of assurance with a conclusion in the negative form. However, when in the
auditor’s judgment an appropriate level of satisfaction has been obtained, the auditor is not
precluded from expressing a conclusion in the positive form regarding the assumptions.15
APPLICABILITY OF ASSURANCE ENGAGEMENTS TO PUBLIC SECTOR
FINANCIAL REPORTS
Year End Historical Financial Information:
GBEs. IPSAS 1 clearly specifies that GBEs are to follow the IASs. Consequently, the audit
expectations for GBEs would be the same as those for the private sector. That is, the annual
financial statements published by the GBEs would be expected to be subject to an audit with a
positive form of conclusion expressed by the auditor. If interim financial statements are issued, a
review would be performed by the auditor.
Public Entities using the Accrual IPSASs. General purpose financial statements issued by all
levels of government using the accrual IPSASs (1-20) would be subject to the full range of ISAs
200-720. That is, an audit would be performed and an audit report with a positive form of
conclusion would be issued by the auditor.
Public Entities using the Cash Basis IPSAS. Most governments currently prepare their
financial reports on the cash or near cash basis. Although the current ISA 800 identifies the “cash
receipts and disbursements basis of accounting” as other than a comprehensive basis specified by
IASs, the Cash Basis IPSAS identifies these statements as general purpose financial statements.
Thus, financial reports by governments using the Cash Basis IPSAS would be subject to audit as
a regular audit engagement under ISA 200-799 with reasonable assurance expressed by the
auditor.
GFS Manual 2001. Although these reports are not considered general purpose financial
statements at the present time, data is extracted from the general purpose financial statements
prepared by the accounting system and reformatted into the statistical report format desired by
13
International Standard on Assurance Engagements 3000, “Assurance Engagements Other Than Audits or Reviews
of Historical Financial Information” (IFAC, December 2003).
14
Pp. 926-935, ISAE 3400, The Examination of Prospective Financial Information (IFAC Handbook of
International Auditing, Assurance, and Ethics Pronouncements; 2004 Edition).
15
Ibid, p. 928.
6
the IMF and the United Nations. Yet, these reports are not presently subject to external
validation. If such validation is requested, it should be considered a special purpose audit
engagement (ISA 800) with a positive conclusion expressed by the auditor. However, a review
could be performed under ISRE 2400 if a higher level of risk is acceptable. In that case, a
negative conclusion would be expressed by the auditor.
Comparative Budget to Actual Financial Statement. For accountability purposes, many
governments prepare comparative budget to actual financial statements at the end of the fiscal
period; yet, these statements are generally not subject to external validation. If external
validation is desired, these statements should be subject to audit as a special purpose audit
engagement (ISA 800) with reasonable assurance provided by the auditor. However, a review
could apply under ISRE 2400 if substantive tests are not to be performed due to cost constraints.
In that case, a negative conclusion would be expressed by the auditor.
At least one country (United States16) specifies that budgetary comparison information be
presented in schedules as part of required supplemental information. Or, if desired, this
information could be presented in a budgetary comparison statement as part of the basic
financial statements. When external validation is desired, schedules would be subject to a
review while statements would be subject to an audit.
Assurance Engagements on Subject Matters Other Than Historical Financial Information:
Prospective financial information will be based on many assumptions about future conditions
and events that may or may not occur. The quality of the information will be dependent largely
on the appropriateness of these assumptions. At least one country (New Zealand17) suggests that
an independent third party should review these assumptions as a valuable aid to reduce internal
bias, and to provide an additional perspective on the validity of the assumptions. Further, in the
State of Victoria in Australia, the Supreme Auditor is required to examine the compilation of the
ex-ante budget reports published by the government, the reasonableness of the assumptions
applied, and the consistency of the application of those assumptions with the budget information.
Legally Approved Budgets. For transparency purposes, governments are encouraged to publish
their legally approved budgets (generally, one year forecasts). Yet, these budgets are not subject
to external validation. If such validation is requested by the legislative body to assure that the
assumptions are reasonable and the presentation is fair/accurate, these budget reports should be
subject to a review under current ISAE 3400 with limited assurance provided by the auditor.
Projected Financial Statements or Schedules. Governments are encouraged to provide
budgetary projections (generally for 3-5 years) as a component of the Medium Term Fiscal
Framework or other projected financial requirements. Yet, these reports are not presently subject
to external validation. If such validation is requested, these statements should be subject to a
review under ISAE 3400 with limited assurance provided by the auditor.
16
Budgetary Comparison Schedules—Perspective Differences, Governmental Accounting Standards Board
Statement No. 41, May 2003.
17
Par. 5.18, Financial Reporting Standard No. 29, Prospective Financial Information (April 1996). This Standard
applies to the Crown and all departments, Offices of Parliament and Crown entities, as well as local authorities.
7
A breakout, by type of report, on these conclusions is provided below:
Regular
Audit
Government
Business
Enterprises
Government
Operations:
Accrual IPSAS
Cash IPSAS
Budget to Actual
Comparative
Statement
Government
Finance Statistics
Manual 2001
Legally Approved
Budget
Projected Budget
Special
Purpose
Audit
Review
Current International
Standards
XX
ISA 200-799
XX
XX
XX
Or XX
ISA 200-799
ISA 200-799
ISA 800 or ISRE 2400
XX
Or XX
ISA 800 or ISRE 2400
XX
ISAE 3400
XX
ISAE 3400
CONCLUSION
Many financial reports are prepared and published by public entities. Yet, only selected year-end
historical reports are subject to external validation. It is sometimes unclear which level of
assurance that an auditor is expected to apply for financial reports that are not considered general
purpose financial statements. This paper has examined the existing ISAs, ISREs, and ISAEs. It
has suggested which public sector financial reports should be subject to external validation and
the level of assurance that should be provided. The table below summarizes the conclusions:
Framework for Assurance Engagements and Related Services
In the Public Sector
Assurance Engagement
Related Services
Nature of
Historical Financial Other Than
Agreed-upon
Compilation
Service
Information
Historical Financial Procedures
(includes year end
Information
reports)
(includes ex-ante
budget reports)
Level of
Reasonable or
Reasonable or
No assurance
No assurance
Assurance
limited, but not
limited, but not
Provided by the absolute, assurance
absolute, assurance
Auditor
8
Report
Provided
Positive or negative
assurance on
assertion (s)
Positive or negative
assurance on
assertion (s)
Factual
findings of
procedures
Identification
of information
compiled
The application of the guidelines identified in this paper to the Structure of IAASB’s Technical
Pronouncements is identified in Appendix B. Although these are not authoritative guidelines,
they hopefully will provide a basis for debate and research to ensure that reliable and verifiable
information is provided to the public in the form of governmental financial reports.
As an independent body, the Supreme Audit Office in each country is responsible for the audit or
review of public sector financial reports at the appropriate tier of government. The organization
that represents the Supreme Audit Offices is the International Organization of Supreme Audit
Institutions (INTOSAI). The Ministry of Finance (or equivalent) in each country is generally
responsible for the preparation and publication of applicable public sector financial reports. The
organization that represents the Ministries of Finance is the International Consortium of
Government Financial Managers (ICGFM).18
18
For further information see www.intosai.org or www.icgfm.org.
9
Structure of Pronouncements Issued by the IAASB
IFAC Code of Ethics for Professional Accountants
ISQCs 1-99 International Standards on Quality Control
International Framework for Assurance Engagements
Audits and Reviews of Historical
Financial Information
ISAs 100-999
International Standards
On Auditing
IAPSs 1000-1999
International Auditing
Practice Statements
Related Services
Framework
Assurance Engagements Other Than
Audits or Reviews of Historical Financial Information
ISREs 2000-2699
International Standards
On Review
Engagements
ISAEs 3000-3699
International Standards
On Assurance
Engagements
ISRSs 4000-4699
International Standards
On Related Services
IREPSs 2700-2999
Reserved for
International Review
Engagement Practice
IAEPSs 3700-3999
Reserved for
International Assurance
Engagement Practice
Statements
IRSPSs 4700-4999
Reserved for
International Related
Services Practice
Statements
10
Structure of Pronouncements Issued by the IAASB
As Applied in the Public Sector
IFAC Code of Ethics for Professional Accountants
ISQCs 1-99 International Standards on Quality Control
International Framework for Assurance Engagements
Audits and Reviews of Historical
Financial Information
ISAs 100-999
International Standards
On Auditing
IAPSs 1000-1999
International Auditing
Practice Statements
Accrual
Standards
(IFRSs &
IPSASs)
Related Services
Framework
Assurance Engagements Other Than
Audits or Reviews of Historical Financial Information
ISREs 2000-2699
International Standards
On Review
Engagements
ISAEs 3000-3699
International Standards
On Assurance
Engagements
ISRSs 4000-4699
International Standards
On Related Services
IREPSs 2700-2999
Reserved for
International Review
Engagement Practice
IAEPSs 3700-3999
Reserved for
International Assurance
Engagement Practice
Statements
IRSPSs 4700-4999
Reserved for
International Related
Services Practice
Statements
IPSAS
Budget to Actual
IMF
Cash
Comparative
Statistical
Standard
Statement
Statements
Legally
Approved
Budget
Projected
Budgetary
Information
11