Auditors and Oversight…A Local Perspective

By Ann-Marie Hogan, City Auditor, City of Berkeley (January 2002)

“Auditor takes the fifth” said the headline; a partner in a major accounting firm was refusing to testify as to whether the auditors had colluded with Enron management in presenting misleading financial information to the public.

Refusing to testify seems startling because the whole purpose of having an audit of a company’s financial statements is to ensure that information that management might prefer not to disclose is, in fact, disclosed. A Certified Public Accountant, regardless of where he or she is employed, owes allegiance to the general public. This is why, in most states, ‘attorney-client privilege” exists for lawyers, but not for accountants.

Why audit?

The annual independent financial audit is primarily for the protection of the stockholders of publicly traded companies. Cities and counties have similar requirements. These audits, and the auditors who conduct them, are required to adhere to specific professional audit standards, the most critical of which is independence from the audited entity.

Threats to independence include conflict of interest (i.e. an auditor can’t own stock in the audited entity) as well as the potential for undue influence on the auditor from the auditee (censorship of the auditor’s reports). Existing audit standards for government and corporate audits have a serious weakness: they ignore the “undue influence” created when the commercial accounting firm enters into lucrative consulting contracts with the auditee. Attempts to rectify this have been successfully beaten back by lobbyists for the commercial auditing firms in the past, but Senator Barbara Boxer is now calling for such legislation. Local government auditors, many of whom have advocated closing this loophole for years, will be watching this one closely.

What about cities?

For local governments and school districts, the annual external financial audit also aims to “provide assurance” that management does not “materially misstate” the financial statements. Whether you are an investor in municipal bonds, a taxpayer, or a Council member, you need assurance that the city’s accounting reports are reliable.

The audit firm is also required to provide an annual Management Letter, which highlights any weaknesses in the entity’s practices and procedures which might affect the financial statements, if weaknesses have come to the firm’s attention in the course of the financial audit.

The risk for financial audits is that the auditors may fail to disclose inaccuracies in the financial statements or weaknesses in the financial and management control systems. This could be cause by lack of professional care; the more significant risk is that the auditors could paint an overly rosy picture of the finances out of fear of offending management (and losing future audit contracts).

In most jurisdictions, the relationship with the outside audit firm is primarily handled by the Finance Department. In other jurisdictions, such as Palo Alto, the competitive solicitation process, as well the day-to-day contact with the firm during the audit, is overseen by the City Auditor. This provides some measure of independence from the City Manager, as the Palo Alto City Auditor reports to the City Council.

The authors of the City Charter for the City of Berkeley recognized the need for additional oversight of the external audit by specifically providing that the contract for the annual financial statement audit is initiated by the Mayor. Notably, this is the only additional power provided to the Mayor by Charter, other than to preside over Council meetings, since the Charter describes a City Manager form of government. As a practical matter, representatives from Finance, City Manager, and the City Auditor meet with the Mayor about bidding the audit contract, as well as reviewing the results and the Management Letter. And, no, the outside audit firm does not generally have other substantial contracts with the City. It does seem interesting that, early in the previous century, the authors of the Charter felt that adding this additional level of oversight for the outside auditors was necessary.

Ann-Marie Hogan was elected City Auditor of Berkeley in December, 1994.

Questions? Comments? Ideas for the Audit Plan? Please e-mail the City Auditor at , mail to 12180 Milvia Street, 3rd floor, 94704. Audit reports available on line at ci.berkeley.ca.us/Auditor.