An estimated 3,000 audit practice units in the United States engage in state and local governmental audits. Most of these (65%) are members of the AICPA’s Governmental Audit Quality Center (GAQC), a voluntary membership center that serves as a comprehensive resource for governmental auditors. But due to inconsistencies, vagaries, and controversies inherent to, or omitted from, the professional standards and nonauthoritative literature, it is understandable why auditors have historically been confused about how and which of these specialized standards are to be applied in various circumstances. This article attempts to identify, address, and clarify these areas of confusion so that auditors can better apply professional judgment to resolve them.
Distinctly different sets of U.S. accounting and auditing standards are applicable to the financial statements of governmental entities and certain other entities that are significantly funded through government assistance. For nongovernmental entities, GAAP is governed principally by FASB, and GAAS by either the AICPA’s Auditing Standards Board (ASB) or the PCAOB. Specialized accounting standards for state and local governments, however are set by GASB, while those applicable to the federal government and its agencies by the Federal Accounting Standards Advisory Board (FASAB). Along with FASB standards, all of these are considered authoritative when applicable and part of GAAP.
In addition to GAAS, generally accepted government auditing standards (GAGAS) apply to certain audits of the financial statements, primarily of those federal, state and local governments and their agencies and others that receive and expend in one reporting year federal assistance funds in excess of a statutory minimum. GAGAS are set forth in a booklet entitled Government Auditing Standards (commonly called the “Yellow Book”) that is issued and updated periodically (2018, https://bit.ly/3IOCy2Y) by the Comptroller General of the United States, Government Accountability Office (GAO).
When Do Government Accounting Standards Apply?
The accounting standards issued by the FASAB embody all authoritative GAAP for financial statements of the U.S. federal government, including all agencies thereof. These standards are available free online in a comprehensive PDF, FASAB Handbook of Federal Accounting Standards and Other Pronouncements, as Amended, which is more than 2,500 pages long in its most current edition (version 19, 2020, https://bit.ly/3ILjGls) as of this writing. Because there is no doubt, uncertainty, or controversy as to when FASAB standards are applicable, and because they are rarely encountered in general audit practice, they are not discussed further in this article.
GASB standards constitute authoritative GAAP for “state and local governments” only but do not clearly define that population. In 1996, FASB and GASB agreed to a definition of “government,” which now appears only in certain AICPA audit and accounting guides, including State and Local Governments (para. 101) and Not-for-Profit Entities (para. 104), which, in turn, contain only nonauthoritative guidance (Category B GAAP). It appears it was never intended that this definition be incorporated directly into any authoritative GASB or FASB standards.
These AICPA guides effectively define “governments” (not “state and local governments”) as “public corporations and bodies corporate and politic” created for the administration of public affairs. It cites a definition of “public corporation” from Black’s Law Dictionary, however, as “as instrumentality of the state governed by those deriving their authority from the state.” Other entities are also considered governmental under the definition agreed to by GASB and FASB if they have at least one of the following three characteristics:
- Popular election of officers or appointment (or approval) of a controlling majority of the members of the organization’s governing body by officials in one or more state or local government.
- The potential for unilateral dissolution by a government with net assets reverting to the government.
- The power to enact or enforce a tax levy.
Furthermore, organizations are presumed to be governmental if they have the ability to issue directly (rather than through a state or municipal authority) debt that pays interest exempt from federal taxation. However, organizations possessing only that ability (i.e., to issue tax-exempt debt) and none of the other governmental characteristics may rebut the presumption that they are governmental if their determination is supported by compelling, relevant evidence (https://bit.ly/3CfgzzM).
GASB standards constitute authoritative GAAP for “state and local governments” only but do not clearly define that population.
Among the series of Technical Questions and Answers (TQA) released in 2017 containing nonauthoritative guidance (discussed in further detail below), the AICPA effectively declared that the above definition of government is to be viewed as a definition of “state and local government,” as that term is used by GASB, that is, “entities are governmental or nongovernmental for accounting, financial reporting, and auditing purposes based solely on the application of the definition of a state or local government” and “an entity that meets the definition should follow accounting standards as promulgated by GASB to prepare its financial statements” (TQA section 9160.31).
Although not defined by either FASB or GASB in any authoritative accounting standard, “state and local governments” are generally understood to include, among others:
- State governments
- Local governments, such as cities, counties, towns, and villages
- Public authorities, such as housing finance, water and other utilities, economic development, and airport authorities
- Governmental colleges and universities
- School districts
- Public employee retirement systems, and
- Public hospitals and other healthcare providers.
Certain not-for-profit organizations that are formed and controlled by a governmental entity are likewise deemed to be governments, and tribal governments (see below) generally are as well; therefore, their financial statements intended to conform to GAAP should be prepared pursuant to GASB standards.
Governmental not-for-profit organizations.
As a rule, not-for-profit organizations are not covered by GASB accounting standards for governments and instead follow accounting FASB-prescribed standards (ASC 958). In some cases, however, distinguishing between a government and a not-for-profit organization is not so simple. For example, a local government may set up a corporation that may, in fact, be tax-exempt under IRC section 501 (c)(3) and therefore has many characteristics of a not-for-profit organization. These organizations are usually considered governmental not-for-profit organizations and should follow governmental GAAP set by GASB.
Tribal governments are technically not state or local governmental entities under the above definition, so one might conclude that they are beyond the scope of GASB’s authority; therefore, there are no authoritative standards expressly applicable to them. FASB (ASC 105-10-05-2) directs that, in the absence of explicit guidance in the authoritative standards, entities should first analogize to other areas of authoritative GAAP before considering nonauthoritative sources. A similar provision appears in GASB Statement 76, The Hierarchy of Generally Accepted Accounting Principles for State and Local Governments.
According to the AICPA audit and accounting guide, State and Local Governments, the federal government considers federally recognized tribes “to be similar to state governments,” and they generally report today using GASB standards (para. 12.91). It should also be noted that many tribes typically report their casino and other significant business operations as enterprise funds of a general-purpose government (i.e., the tribe), as mentioned in the guide (paras. 12.09, 12.93). (GASB standards applicable to enterprise funds differ from FASB standards only in limited respects primarily with respect to measuring postemployment benefit liabilities and certain minor presentation and disclosure matters.) Other tribal governments, however, prepare their financial statements on a non-GAAP, statutory or regulatory basis, which is considered a special-purpose framework. A standard for reporting on financial statements prepared on a special-purpose framework is provided in GAAS (AU-C 800).
The foregoing notwithstanding, some entities have sought the option to prepare their financial statements in accordance with FASB standards rather than GASB standards for the following reasons:
- Banks or other third parties requested it.
- Financial and accounting personnel are more familiar with them.
- Tribes and other government entities view them as preferable for certain business-type activities (e.g., casinos, public utilities, hospitals) because their financial statements would be more comparable to other privately held businesses operating in the industry.
Although not acknowledged expressly by GASB in its standards or other literature, NAFOA has effectively expanded the scope of GASB’s authority and recognized it on its website without qualification or exception as applicable to “tribal, state, and local governments.”
In a series of technical Q&As (TQA) issued in 2017, the AICPA provided non-authoritative guidance for issuing audit opinions on the financial statements of tribal governments that choose to prepare them in accordance with FASB standards rather than GASB standards. In such guidance, auditors were advised to evaluate whether the accounting principles and presentation used in the financial statements and related notes were materially different than those required by GASB. Only when the differences in presentation and disclosures were determined to be immaterial could an auditor consider providing an unmodified audit opinion with regard to GAAP compliance. If the differences were determined to be material, the auditor should modify the opinion, because the financial statements, or an element thereof, were materially misstated or misrepresented with respect to GASB GAAP.
This nonauthoritative guidance also cautioned auditors against reporting on the financial statements of tribal entities prepared using FASB standards as a special-purpose framework; instead, they provided the alternative of issuing what is termed a “dual audit opinion.” Under the dual opinion option, when financial statements are prepared using FASB principles (although an adverse opinion would still be issued with respect to noncompliance with GASB GAAP in the audit report, if appropriate), additional language may be added, including an unmodified opinion on compliance of the financial statements with FASB standards. An illustrative report with a dual opinion is presented in the TQAs (sections 9160.32, .34–35).
In the opinion of this author, the dual opinion approach is conceptually flawed and should be highly controversial. In that regard, the Native American Finance Officers Association (NAFOA), which holds a seat on the GASB’s Advisory Council (GASAC), a body responsible for consulting with GASB on concerns of tribal governments and other technical matters, objected in 2018 to the dual opinion option. It asserted that “confusing opinions counteract the objectives of accounting standards and consequently impact the economic health of Indian Country” (https://bit.ly/3HCpkoE). More specifically, NAFOA has further asserted that “negative audits, in the form of dual audit opinions, can impact federal funding, bank loans, the ability to raise capital, and the potential loss of economic opportunities” (https://bit.ly/3hLbbuB).
Although not acknowledged expressly by GASB in its standards or other literature, NAFOA has effectively expanded the scope of GASB’s authority and recognized it on its website without qualification or exception as applicable to “tribal, state, and local governments [emphasis added]” (https://bit.ly/3IIKOBu).
To add to the confusion, the AICPA audit guide acknowledges that some tribes do not meet the FASB/GASB-agreed definition of a government; it refers users to TQA section 9160 (discussed above) for additional guidance (para. 1.03).
Given the above analysis, the nonauthoritative guidance contained in both the AICPA’s TQAs and the guide notwithstanding, in the opinion of this author, FASB standards are neither currently generally accepted nor widely used for financial statements of tribal governments or components thereof (except for enterprise funds, such as casino operations when the FASB/GASB differences are not material). Therefore, an auditor should be hard-pressed to justify issuing a clean opinion as to GAAP compliance on financial statements that depart materially from GASB standards.
When Do Yellow Book Auditing Standards Apply?
Many audit professionals have apparently long held the intuitive but mistaken notion that GAGAS, as prescribed in the Yellow Book, must be observed for all governmental entities (among others), i.e., those entities that are required to report using government accounting prescribed by either GASB or the FASAB. This mistaken belief may arise because the language setting forth the applicability of these standards is rather subtly presented in GAGAS; therefore, it is easily overlooked or misinterpreted. The only relevant language appears without a caption using the word, “applicability,” in the latest (2018) edition of the Yellow Book as follows:
Laws, regulations, contracts, grant agreements, and policies frequently require that engagements be conducted in accordance with GAGAS. In addition, many auditors and audit organizations voluntarily choose to conduct their work in accordance with GAGAS. (para. 1.08)
Despite the GAO language advocating voluntary adoption, this author does not recommend that auditors encourage clients to engage them to apply GAGAS when not required, unless the client has a good reason.
This means that the application of Yellow Book auditing standards can be required only in the presence of applicable laws, regulations, contracts, grant agreements or policies, but otherwise may be applied at the discretion of the client, such as at the request of a creditor, or as a result of a plan to seek government assistance grants in the future. The Yellow Book goes on to say:
The requirements and guidance in GAGAS in totality apply to engagements pertaining to government entities, programs, activities, and functions, and to government assistance administered by contractors, nonprofit entities, and other nongovernmental entities [but only] when the use of GAGAS is required or voluntarily adopted. (para. 1.08)
Voluntary adoption of GAGAS when not required is discussed further in the Yellow Book as follows:
Even if not required to do so, auditors may find it useful to follow GAGAS in conducting engagements pertaining to federal, state, and local government programs as well as engagements pertaining to state and local government awards that contractors, nonprofit entities, and other nongovernmental entities administer. Though not formally required to do so, many audit organizations … voluntarily follow GAGAS. (para. 1.11)
Despite the GAO language advocating voluntary adoption, this author does not recommend that auditors encourage clients to engage them to apply GAGAS when not required, unless the client has a good reason. Doing otherwise would unnecessarily tie up members of a firm’s audit staffs longer, present additional business risk, and—most significantly—add unnecessary costs to the audit, which could be viewed as unethical if passed on to the client without proper disclosure of the availability of the less costly option at the client’s discretion.
The Yellow Book’s GAGAS requirements apply (along with others) under the Federal Single Audit Act whenever a governmental or nongovernmental entity expends a certain total (currently $750,000) or more of federal assistance awards in any given reporting year. The GAQC reports that 36,661 single audits, covering federal grants totaling almost $1.3 trillion, were performed by its members and nonmembers in 2018.
Note that the federal Yellow Book/single audit obligation is triggered by the aggregate dollar amount of cash expenditures rather than receipts and thus can be avoided by the careful timing of cash outflows. The term “single audit” describes certain regulatory procedural and reporting requirements that apply supplementally to a Yellow Book audit when required by federal law, but not if only by state or local legislation, contract, or client choice.
Sometimes federal assistance awards do not come directly from federal agencies, but are instead from pass-through grants, paid with federal funds administered by state or local governmental agencies. Such pass-through grants must be counted towards the $750,000 threshold.
How to Report under Yellow Book Standards
The Yellow Book is built upon GAAS, all sections of which are incorporated therein (para. 6.01). However, GAGAS includes additional ethical principles, general standards, and reporting obligations regarding such matters as internal control, waste and abuse, and compliance, and the standard audit report form on financial statements audited pursuant to GAGAS is dictated in most substantive respects by GAAS. It differs from reports issued in non–Yellow Book audits solely by a mandatory reference to GAGAS in addition to GAAS in describing its scope.
Illustrative GAGAS-compliant audit reports can be found in the AICPA audit and accounting guide Government Auditing Standards and Single Audits (https://bit.ly/3IKfJ0t).
How to Report under both Yellow Book and PCAOB Standards
Some nongovernmental entities that are subject to Yellow Book standards as a result of expending federal assistance funds in excess of $750,000 annually may also be public companies that meet the PCAOB definition of “issuer.” In such instances, Yellow Book standards may be used in conjunction with PCAOB standards because the audit client is a PCAOB-defined “issuer,” and the auditor must be a PCAOB-registered firm. To perform an audit under GAGAS, however, the audit must also comply with GAAS. Consequently, the audit report and its title must comply with PCAOB standards except that when describing the audit scope, the report must refer to all three sets of auditing standards: GAAS, Yellow Book and PCAOB.
Even when clients do not meet the PCAOB definition of “issuer,” they may opt for their audits to be conducted in accordance with PCAOB standards (perhaps because of a future public offering), or they may be required by a governmental agency, another regulator, or a contractual agreement to do so. In such cases, they must comply with GAAS and follow the guidance in the preceding paragraph. However, if the audit firm were not PCAOB-registered, the audit report would not be titled as prescribed by AS 3101. (See AU-C section 700.44, AU-C 9700.17–19 and PCAOB’s AS 3101 and Staff Guidance section 300.04 for more detailed reporting guidance.)
Government auditing is a highly specialized and complicated area of practice engaged in by less than 10% of the total number of firms that perform audits.
Issuers of municipal securities.
State and local governments often issue debt securities (municipal securities or municipal bonds) that are exempt from the federal securities registration and reporting requirements applicable to other securities offered to the public. Accordingly, governmental entities that issue such municipal securities are not “issuers,” as that term is defined by the PCAOB and the securities laws (another source of confusion, perhaps); therefore, audits of their financial statements and reports thereon are not required to comply with PCAOB auditing standards. Moreover, as stated in a 2007 white paper, “Disclosure and Accounting Practices in the Municipal Securities Market,” the SEC has not been explicitly authorized to regulate accounting and financial reporting standards for municipal issuers and has no direct influence over the GASB and the standards it sets, nor can it designate GASB standards as “generally accepted.” Furthermore, the SEC has no express authority to require municipal securities issuers to follow GASB standards (SEC Press Release 2007-148, “SEC Chairman Cox Calls for Improved Investor Protections in the Market for Municipal Securities,” July 26, 2007, https://bit.ly/3sHdEwu).
A Unique Environment
Government auditing is a highly specialized and complicated area of practice engaged in by less than 10% of the total number of firms that perform audits. Auditors must be familiar with the special rules and requirements that apply to government audit, rules and requirements which do not apply to financial statements or audits outside of the government sector but in some cases may be adopted voluntarily. It is for this reason that the Yellow Book has minimum requirements for qualifying CPE. It is hoped that this article will help identify and clarify common areas of confusion so that auditors can better apply professional judgment to resolve them.