Adopt Private Sector Practices of Billing for Financial Audits

The private sector s billing practices should be adopted for financial audit services performed by the State Auditor s Office.


Background
The State Auditor s Office (SAO) consists of about 292 professional auditors and support staff who perform various functions for the state. The vast majority of SAO s resources go toward conducting financial, performance and employee classification audits for state government.

Over half of the SAO s auditing efforts are for financial auditing. Financial audits include the annual statewide audit, pension fund audits, financial audits of individual agencies and a n umber of statutorily required audits. In the SAO 1992 audit plan, financial auditing accounted for 169,730 hours 56 percent of a total 303,600 direct audit hours. 1 In addition, 293,452 hours were budgeted for various support functions. These hours, which directly and indirectly support financial, performance and classification audit activities, included computer audit support, research, legal, management, administr ative support, training and employee leave. 2

For the 1991-92 biennium, SAO had total expenditures of $22.8 million. Eighty-six percent of SAO s expenditures were funded through general revenue and 14 percent ($3.3 million) were reimbursements from state agencies for the costs of performing the audits. 3 According to SAO s budget request for the 1994-95 biennium, out of a two-year budget of $27.5 million, only $1.8 million, or 7 percent, will be funded through reimbursements from state agencies.

Traditionally, SAO has billed state agencies and universities for the hours incurred auditing federal fu nds and certain special funds. In the case of federal grants, state audit costs for auditing federal grants are allowed by federal laws and regulations. Indeed, charging the full direct and indirect costs of auditing federal grants ensures that the state i s fairly reimbursed for efforts conducted on behalf of federal programs.

A strong case can be made for fairly and proportionally allocating the costs of performing financial audits to all state funding sources, whether they be general revenue, special fun ds, university local funds or dedicated funds. However, only a small part of SAO s funding has come from state agency reimbursements.

Financial Audits of Non-General Revenue Activities
There is ample evidence to support the idea that a much greater part of SAO s financial audit efforts should be paid by non-general revenue sources.

First, for the 1992-93 biennium, $25.6 billion in state appropriations were from non-general revenue sources. This was 43 percent of total appropriations for the biennium. 4

Second, according to the latest audited financial statements for the State of Texas, general and special revenue fund expenditures totaled $21 billion, with 74 percent of the expenditures coming from special revenue funds. 5 Special revenue funding includes some of the state s largest program areas such as transportation, education and human services. The state also had assets totalling $72.8 billion net of fixed assets and general long-term debt. Only 3 percent of these assets were from general funds, with 4 percent from special funds; 24 percent were from colleges and universities; and 61 percent from fiduciary funds (mostly pension funds). 6 General and special fund assets totalled $4.6 billion, with 59 percent from special funds and 41 percent from general funds.

Third, financial audit activity is assigned based on the size, complexity and risk of the funds and agencies being audited. In general, the larger the agency and the more complex its programs and funding, the more audit hours are assigned. For exam ple, planned direct financial audit hours for fiscal 1992 were: 4,500 for the Teacher Retirement System; 11,600 for the Department of Human Services; 5,750 for the Texas Department of Transportation; 8,700 for the University of Texas System; 5,500 for the Texas A&M System; and 8,000 for a statutorily mandated audit of the Texas Department of Insurance s Liquidation Division. 7 These are direct audit hours and do not include substantial support services such as computer audit support, auditor training, audit management and general administration. Many of the organizations in the above example receive significant funding from special funds, dedicated funds, federal funds and other non-general revenue sources.

Whether one looks at state appropriations, state expenditures, state assets, or state agencies and their programs, it is clear that an enormous amount of non-general revenue financial activity is subject to financial auditing. Yet the costs of conducting f inancial audit services are paid almost entirely by the General Revenue Fund.


Recommendation
To ensure that financial audit costs are properly allocated to all state funds, the Legislature should require that the State Auditor s Office (SAO) charge all its expenses for conducting financial audits to the state agencies, state institutions and special and dedicated funds audited.

SAO s general revenue funds should be reduced by $5 million each year, beginning September 1, 1993, $5 million being a conservative estimate of the annual costs of conducting financial audits. Instead, SAO s costs for performing financial and financially related audits would be funded by billing state agencies, universities and all other organizations audited by SAO. General and non-general revenue funds would be charged proportio nally, based on the actual audit effort involved in auditing those funds. Agencies and institutions would be required to pay these charges out of budget allocations without specific adjustment for this new cost.

The costs should be calculated based on professional cost accounting practices and include all direct and indirect support costs involved in the state s annual financial audit. SAO already has an automated time-keeping system documenting audit effort by agency, fund and audit activity, thus ensurin g that the correct agencies and the funding sources will be accurately charged. The billings would be prepared by SAO using interagency transfer vouchers.

To ensure proper cash flow to pay for SAO s operations, SAO would be allowed to bill on a regular ba sis throughout the year, based on estimated audit efforts. At the end of each fiscal year, a final adjustment would be made to correct for any differences between estimated and actual financial audit costs.

The remainder of SAO s activities would continue to be funded from the state s General Revenue Fund. These activities include performance auditing, fraud investigations, classification reviews and special legislative projects.

Another recommendation in this report proposes the transfer of SAO s class ification function to a new central personnel office. This function would be funded through fees paid by state agencies on the basis of the number of employees in each agency.


Implications
There would be several benefits in having the SAO bill for financial audit services.

First, by emulating the billing practices of private sector accounting firms, there would be more accountability in the funding of financial audit services. Audit fees would be shared proportionally by the proper sources of funding and ensure that the General Revenue Fund does not subsidize the costs of auditing other funds.

Second, having state agencies pay for financial audit services would provide an incentive for agencies to cooperate fully in the audits, ultimately reducing audit efforts and costs. In the private sector, corporations typically use their employees and inte rnal auditors to prepare the ground work for the external auditors. Fortune 500 corporations, which can have audit costs of several million dollars annually, typically go to great lengths to keep billable audit hours down.

Third, establishing the recommended audit billing policy would provide a funding source if SAO is subsequently required by the Legislature to perform a greater number of financial audits, such as financial reviews of school districts or other state-funded entities.

The only disadvantage is that agencies would incur the costs without additional funding. However, annual financial audit costs when allocated to over 200 agencies and multiple funding sources, would not unduly burden state agencies operations. Also, the larger agencies, representing the bulk of financial audit activity, would pay for the majority of the audit costs and much of it would be from non-general revenue sources. Financial aud it costs would be an extremely small portion of the budgets of large agencies.


Fiscal Impact
SAO s 1994-95 request for legislative appropriations does not specifically identify how much of its funding is allocated to financial auditing. However, its 1992 audit plan indicated that 56 percent of its direct audit hours were for financial and financially related audits. When this percentage is applied to SAO s requested general revenue funds, SAO s annual financial audit costs are estimated to be $6.6 million in 1994 and $6.9 million in 1995 (net of $900,000 already estimated to be reimbursed annually).

The recommendation would reduce SAO s general revenue appropriations by $5 million per year, with those costs instead charged to state agencies and state institutions. This represents a savings of $5 million annually to the state s General Revenue Fund, as state agencies would pay for the financial audits out of their existing budgets. Any excess amounts billed over $5 million annually would be subject to reappropriation by the Legislature.

Fiscal Savings to the Change in
Year General Revenue Fund 001 FTEs

1994 $5,000,000 0
1995 5,000,000 0
1996 5,000,000 0
1997 5,000,000 0
1998 5,000,000 0



Endnotes
1 Texas State Auditor s Office, State Auditor s Office Operating Plan Fiscal Year 1992 (Austin, Texas, August 31, 1991), appendix 1, pp. 4, 5, 14, and 18.
2 Ibid., pp. 21, 26.
3 Texas State Auditor s Office, Requests for Legislative Appropriations Fiscal Years 1994 and 1995 (Austin, Texas, November 2, 1992), p. 3.
4 Texas Legislative Budget Board, Fiscal Size Up 1992-93 Biennium (Austin, Texas, July 1992), pp. 1-1 and 1-2.
5 Comptroller of Public Accounts, Texas 1991 Comprehensive Annual Financial Report (Austin, Texas, February 28, 1992), p. 26.
6 Ibid., pp. 24-25.
7 Texas State Auditor s Office, State Auditor s Office Operating Plan Fiscal Year 1992 (Austin, Texas, August 31, 1991), appendix 1, pp. 2-4, and 15.