DIFFERENCES IN MUNICIPAL VS. COMMERCIAL AUDIT PLANNING ANALYTICAL PROCEDURES

By Eric N. Johnson and Laurence E. Johnson

Audits of governmental entities, including municipalities, represent a significant and expanding segment of the audit market, and thus may be a potential growth area for the audit practices of many CPA firms. Differences in financial reporting practices and the audit environment of municipalities compared to commercial enterprises, however, may present a challenge to CPAs who are considering expanding their audit practices to include municipal clients. A survey was made of practicing auditors with experience in both municipal and commercial audit engagements. These auditors were asked to rank the relative importance of several categories of analytical procedures in audit planning for each type of engagement.

Analytical Procedures in Audit Planning

Analytical procedures involve the auditor's evaluation of financial information through the study of plausible relationships among financial and nonfinancial data. Variations from expected relationships may reflect unusual transactions, accounting or business changes, or misstatements in the financial statements. Because these variations may indicate the existence of specific risks relevant to audit planning, SAS No. 56 requires the use of analytical procedures in the planning and review phases of all audits. SAS No. 56 identifies the five major categories of analytical procedures as follows:

* Comparisons of client's current-year financial data with prior-year data,

* Budget-to-actual comparisons of client's financial data,

* Reviews of relationships among client's financial-statement elements for conformity with expected patterns,

* Comparisons of client's financial data with industry financial data, and

* Comparisons of client's financial data with relevant nonfinancial data.

Due to environmental differences between municipal and commercial audits, and differences in financial reporting practices between the two types of engagements, auditors may use different procedures, or place different levels of reliance on procedures, in planning governmental and commercial audits. For example, ratio analysis, which is one type of procedure used to review relationships among financial-statement elements, relies heavily on measures of profitability. Most measures of profitability, however, are normally not applicable in municipal financial statements.

Another analytical procedure that might be applied differently in municipal audit planning is budget-to-actual comparisons of financial data. The AICPA's audit guide for state and local governmental entities suggests the budget and the budgetary process is more significant in financial accounting and reporting for governments than for commercial entities. In addition, governmental budgets typically have binding legal authority within the governmental unit. Thus, because noncompliance with a legally adopted budget may be considered an illegal act under SAS No. 54, auditors should pay special attention to compliance with a city's legally adopted budget.

To identify possible differences in how auditors apply analytical procedures in planning municipal and commercial audits, and to understand the nature of these differences, we administered a nationwide survey of practicing CPAs who have both municipal and commercial audit experience.

The Survey

One hundred and eighty-three CPA firm offices with municipal audit clients nationwide were identified from a review of recent comprehensive annual financial reports (CAFRs). A questionnaire that addressed analytical procedures for municipal and commercial audits was sent to the engagement partner, manager, and in-charge on each municipality's audit team, for a total sample of 549 (3 x 183). One hundred and fifty-three (28%) usable responses were received and used for the analysis.

Auditors who responded averaged 35 years of age and 140 months of auditing experience. All respondents had audited at least one municipality within the past three years; 51% had audited six or more municipal clients. More than 92% had also audited at least one commercial client during the same period.

Comparison of Analytical Procedures in Audit Planning

Auditors were asked to indicate the likelihood of applying each of the five categories of analytical procedures listed in SAS No. 56 in audit planning for their municipal and commercial clients in separate rankings. The rankings were on a scale of 1 to 5, with 1 indicating "most likely to apply" and 5 indicating "least likely to apply." The Exhibit shows the rankings of the five analytical procedure categories for municipal and commercial engagement planning, and a comparison of the average rankings for each category, for both types of engagements.

Budget-to-Actual Comparisons. Auditors assigned an average rank of 1.69 on the five-point scale to budget-to-actual comparisons of client financial data for municipal audit planning. For commercial audit planning, the average rank for this category of procedures was 3.50. The difference in rankings verifies that auditors view the budget as more important in planning municipal engagements than commercial engagements.

Current-Year to Prior-Year Comparisons. Comparison of the client's current-year with prior-year financial data was ranked as the most important category for commercial audit planning (1.22), and was considered the most important category of planning analytical procedure overall. Auditors also considered this procedure to be nearly as important as the comparison of budget-to-actual data (1.76 vs. 1.69) for planning their municipal audits.

Relationships Among Financial Statement Elements. The review of relationships among the client's financial statement elements was the second most important category of analytical procedures for commercial audit engagement planning (2.33). In addition, auditors ranked the review of financial statement relationships as third most important for municipal audit planning, but less important than for planning commercial audits (2.84). The difference in category rankings between engagement types may reflect the lack of a clearly defined "bottom line" in the financial operations of many municipal operations. Substantial differences between the income statement for commercial clients and the statement of revenues, expenditures, and changes in fund balance for municipalities may make income-based ratio analyses (e.g., gross profit and net income measures) less meaningful, and therefore less useful, in the analysis of municipal financial statements for audit planning purposes.

Other Comparisons. Comparisons of client's financial data with relevant nonfinancial data were ranked fourth for planning municipal engagements (4.12) and fifth for planning commercial engagements (4.27). Industry data comparisons with client data were ranked fourth in planning commercial engagements (3.68) and fifth for municipal engagements (4.58), the lowest-ranked category of analytical procedures overall. This finding probably reflects the potential for dissimilarities between similarly designated governments. Dissimilarities between the financial statements of different cities would make comparisons between cities less useful in municipal audit planning. On the other hand, the availability and reliability of industry data appear to make industry-client comparisons more useful in planning a commercial audit engagement. *

Eric N. Johnson, PhD, CPA, is an assistant professor of accounting at the University of Toledo, Toledo, Ohio. Laurence E. Johnson, PhD, CPA, is an assistant professor of accounting at Colorado State University, Fort Collins, Colorado.

Municipal Audits Commercial Audits

Analytical Procedure Category Rank Order Rank Order

Current-year to prior-year comparisons of financial data 1.76 2 1.22 1

Budget-to-actual comparisons of financial data 1.69 1 3.50 3

Review of relationships among financial statement elements 2.84 3 2.33 2

Comparisons of financial data with industry

data 4.58 5 3.68 4

Comparisons of financial data with

nonfinancial data 4.12 4 4.27 5

Scale rankings for each category in audit planning are 1 = "most likely to apply"
to 5 = "least likely to apply."

Editor:
Douglas R. Carmichael, PhD, CPA
Baruch College

DECEMBER 1995 / THE CPA JOURNAL