Highlights On Audits of Illinois Municipalities
Wm. A. Froehlich

MUCH HAS BEEN WRITTEN about accounting principles and auditing theory and procedures applicable specifically to cities and villages, including the excellent publications of the National Committee on Governmental Accounting and, accordingly, no useful purpose would be served if a paper such as this were to merely duplicate such material. Conversely, however, there appears to be a need on the part of public accountants and, especially to those new to the field of municipal auditing, for material concerning the "what", "why" and "how" of factors peculiar to municipal accounting.

It is the intent of this article to set forth in brief form the essential elements and peculiar characteristics of municipal audits that must be understood by the accountant in order for him to perform a satisfactory audit. Accordingly, with this point of view in mind, the material following is presented under three major sections: (1) Legal Fiscal Requirements of Illinois Municipalities, (2) The Engagement, and (3) Special Characteristics Peculiar to Municipalities.

Legal Fiscal Requirements of Illinois Municipalities

It is essential that public accountants interested in performing audits for Illinois municipalities be thoroughly familiar with the laws which pertain to the fiscal affairs of cities and villages. The "Cities and Villages Act" of the Illinois statutes and the "Municipal Audit Law" sets forth substantially all of the various rules, regulations, powers, restrictions, limitations, etc. under which municipalities operate. While it is recognized that the accountant should not attempt to interpret the law, it is necessary for him to be familiar with the accounting aspects of the law in order for him to perform an intelligent audit of an Illinois Municipality.

Not only must the accountant be well informed about the accounting requirements as contained in the Illinois statutes but, in addition, must have an adequate understanding of the accounting requirements contained in the ordinances of the municipality for which he is furnishing audit services.

Therefore, the audit program must necessarily include audit procedures which will reveal compliance or possible non-compliance with the applicable legal requirements. In this connection the accountant must be aware that legal requirements of the specific city or village always take precedence over what might otherwise be considered sound accounting practice.

The Engagement

In contemplating an audit engagement for a municipality the accountant would be well advised to give careful consideration to the following important factors:

1. The type of an audit he is to perform:

The importance of this factor cannot be overemphasized, for unless the nature and exact scope of the audit is clearly set forth and understood as between the accountant and his client, serious misunderstandings can arise as to the auditor's responsibility.

In this connection considerable confusion exists in the minds of some municipal officials as to the definition and scope of an audit. This confusion is not lessened by the numerous definitions and types of audits presented in various publications issued for the benefit of fiscal officers. The greatest area of confusion, however, exists in differentiating between a "general audit" and a "complete or detailed audit." In the former, the audit involves substantiation of financial statements and accounts by means of tests, while the latter type of audit entails examination of all items entering into accounts and transactions.

It is obvious that if in a given illustration a municipality desired a complete or detailed audit, sampling techniques and test-checking of transactions by the auditor would not meet the requirements of the engagement. Conversely, if the auditor assumed that he was to perform a complete audit of all transactions of all funds and so employed his time, it would appear that he might have difficulty in collecting his total charges if the municipality was under the impression that generally accepted auditing procedures and standards were to be employed. Further in this connection, the fee arrangement is generally based upon the scope of the proposed audit and if the exact nature of the examination is unclear, an unsatisfactory fee realization might result.

Accordingly, in order to define the extent and scope of the examination it is suggested that consideration be given to the following checklist:

(a) Determine the specific fund or funds to be audited.

(b) Determine the fiscal period or special period to be examined.

(c) Briefly review the system of internal control, accounting practices and the condition of the records to determine the degree of reliance that

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could be placed thereon and the extent that sampling techniques could be employed.

(d) Determine the basis of accounting employed : cash, modified cash or accrual.

(e) Determine the form of government adopted by the municipality.

(f) Determine the existence of special services and/or utilities operated by the municipality, such as: electric, gas, water and sewer, etc., and whether or not they are to be included in the scope of the examination.

(g) Determine audit requirements as set forth under the Municipal Audit Law.

2. The audit proposal:

Upon completion of the suggested preliminary steps the accountant would then be in a position to develop and submit an intelligent audit proposal, and if required an estimate of the cost of performing the engagement. The proposal should be in writing and should set forth in unambiguous language the exact extent and scope of the examination. Suggested elements for incorporation in a proposal, though not all-inclusive, are listed briefly, as follows:

(a) Period to be covered.

(b) Funds to be included, naming specific funds to be excluded, if applicable. (Normally, if none of the funds are to be excluded, then the proposal letter would state that "all funds are to be audited.")

(c) Type of examination:

(1) Limited examination—restricted as to certain areas, cash receipts and disbursements only, review of accounts without the employment of any or all generally, accepted auditing procedures, etc.

(2) Complete or detailed audit—as defined heretofore.

(3) General audit—based on test-checking and sampling techniques and the employment of other generally recognized auditing procedures.

(d) Type of report—short form, detailed accountants' report, inclusive of comments on the internal control and accounting practices of the municipality, etc.

(e) Responsibility of the auditor and restrictions on rendering an opinion, if applicable, and the areas of possible denial of opinion; for example, unsubstantiated opening general ledger balances, nonconformity with procedures prescribed by statute or local ordinance, etc.

(f) The estimated cost, and if deemed necessary, arrangements for payment.

In addition, it is highly desirable, under certain circumstances, to make provision for possible extension of audit procedures, where, for example, internal control appears to be highly unsatisfactory, irregularities are apparent, etc. Such provisions generally require agreement on the part of both parties, including adjustment of the fee arrangement, before the extended audit procedures are put into effect.

Upon acceptance of the audit proposal by the municipality the auditor should follow to see that proper approval and authorization is contained in the minutes of the council, or other authorized body, and to determine that funds have been appropriated to cover the cost of his services. Without the latter two actions being taken by the municipality, especially if controversies arise, the auditor might have difficulty in collecting his fee.

Due to the political nature of the form of government generally found in all Illinois municipal corporations, requiring the "management" to be elected by the citizens of the municipality, it is understandable that the elected officials have varying business experience, ranging from the housewife to the business executive. Coupled with the ranges in exposure to good business practices, including the understanding, or lack of understanding of accounting concepts, it is generally true that some turnover in officials takes place, from election to election.

These two factors become quite important to the independent auditor, for while requirements of the various statutes and ordinances might appear to have been followed, the manner of accounting for the municipalities resources and obligations could have been improper, due to ignorance, incompetence or other deficiencies of the elected body and/or

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employee. It is, therefore, essential in commencing the engagement that the auditor make a comprepensive review of the system of internal control and accounting practices employed by the municipality.

The second step in the audit program generally should be the inspection of all applicable ordinances and minutes relating to fiscal matters for the period under review so that knowledge is had of all established or authorized financial requirements and transactions for subsequent verification and tracing into the records.

In this latter connection, it is important to note that many revenue bond indentures provide for special accounting treatment of revenues derived from the activity for which the bonds were issued. Such provisions generally require that certain amounts be set aside monthly or periodically into "Maintenance and Operation Accounts," "Bond and Interest Sinking Fund Accounts," "Bond Redemption Accounts," "Special Reserve or Surplus Accounts," etc. It is absolutely essential that the auditor read such indentures carefully so that he is thoroughly familiar with the various provisions contained therein.

As to auditing techniques to be employed in the engagement as a whole, generally recognized auditing procedures should be used and to the extent deemed necessary in the circumstances. Again, as stated previously, excellent material is available on the subject. However, as to accounts and factors peculiar to a municipality, a few highlights on such matters are presented in the final section of this article, as follows:

Special Characteristics Peculiar to Municipalities

1. Definition of a fund :

In Illinois, the term "fund" as used in the governmental accounting sense can pertain to one or more of the following:

(a) A special tax levied for a particular purpose or activity.

(b) Activities or accountabilities created by action of the corporate authorities of the municipality itself.

(c) Accountabilities which are clearly indicated or required in the opinion of the professional accountant in order to account properly for assets, liabilities and transactions of a special activity.

In summation, a fund is both a sum of resources and an independent accounting entity, providing for a self-balancing group of accounts consisting of the various assets, other resources, liabilities, obligations and available balances or deficit of the activity. In addition, accounts are maintained to permit identification of revenues and expenditures and receipts and disbursements to the fund to which they apply.

2. Appropriation and tax levy ordinances:

In Illinois municipalities all expenditures must be provided for in a legal instrument called an "Appropriation Ordinance." A budget is generally prepared by the Manager and Council in Council-Manager cities or the Finance Committee in Mayor-Council cities, taking into consideration each function, activity and object of expense. The budget is then drafted into an appropriation ordinance, setting forth the source of revenue from which each expenditure is to be met, either from tax levies or from other revenues, such as licenses, fees, fines, parking meter receipts, etc., or from both. Upon being duly adopted, the appropriation ordinance becomes the legal authority for incurring encumbrances or expenditures.

Immediately following the development and adoption of the appropriation ordinance, a tax levy ordinance is prepared for filing with the County Clerk, setting forth by funds the various items to be met from tax levies. In this connection, it must be recognized that maximum tax rates exist and even though a municipality develops a tax levy ordinance in excess of its tax extension rate, it will only receive the legal maximum.

The auditor should review the two respective ordinances and during the course of his examination should determine whether expenditures have or have not been made in conformity therewith. Proper disclosure should be made in the auditor's report where nonconformity has been noted.

3. Taxes receivable:

In the state of Illinois real estate and personal property taxes are not placed in collection until approximately 14 months after assessors have established property valuations. Accordingly, at the end of each municipality's fiscal year, regardless of which month of the year was selected for the end of the fiscal period, a receivable exists. This is true whether the municipality is on the cash or accrual basis. Such receivables are not collected 100%, for based on previous tax collection experience it is known that generally a certain portion of the tax levy will not be collected in the normal way and, in addition, certain allowable fees and collection costs are retained by the tax collection officers. For those municipalities maintaining their records on the accrual basis of accounting this situation gives rise to the establishment of reserves for loss and costs on taxes receivable. Further, in this connection, it is important to note that the assessment made in the "levy year" does not give rise to a specific receivable from taxpayers until the following year. In general, the adoption of a tax levy ordinance establishes a maximum total to be charged to property owners; however, until rates have been determined and taxes extended the individual charges to taxpayers are not known. Hence it is usually necessary to adjust the amounts recorded as tax levies receivable (if the accrual basis of accounting is used) when final extensions are completed.

When a municipality is on the cash basis of accounting it normally picks up the net amount of

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the proceeds, as remitted to it by the tax collection officers, by debiting cash in bank and crediting revenue from tax collections. Conversely, when a municipality operates on the accrual basis of accounting it normally would debit cash in bank for the net proceeds of the remittance, credit taxes receivable for the gross amount of the tax collection and charge off the difference, representing fees and costs, to a reserve for loss and costs account.

Procedures for verification of the total tax levy, taxes collected and remitted, costs of collection and taxes held in reserve by the County Collector, would be by direct correspondence or visit to the offices of the County Clerk and the County Treasurer. In addition, collections applicable to prior years' taxes would be reviewed and verified in the same manner.

4. Tax anticipation warrants :

In connection with the preceding comments, a logical question could arise, "If the municipality does not receive collections on its tax levies until the following year, how can it meet its current operating cost?" In general, the Illinois statutes provide for this situation by enpowering the municipality to issue and sell tax anticipation warrants to the extent of 75% of its tax levy. Certain special provisions apply to the issuance of general corporate tax warrants when a municipality has a working cash fund. Such warrants are redeemable only from collections of the tax levy against which they were drawn. If collections prove insufficient to cover the outstanding tax anticipation warrants, payment cannot be made from collections of any other tax levy year. In addition, it is important to note that interest payments applicable to tax anticipation warrants cannot be included in the tax levy ordinance, even though payments can only be made from collections of the applicable tax levy.

Audit procedures would generally be identical to those employed in the verification of outstanding bond indebtedness.

It is of interest to note that some municipalities have discarded the use of tax anticipation warrants in favor of legal establishment of working cash funds.

5. Abatement of tax levies for bond indebtedness and interest liability:

As was stated previously, each element of expense to be incurred during the ensuing year, to be met from property tax revenues, must be provided for in the tax levy ordinance. Accordingly, for each bond issue provision must be made in the initial year of issuance to levy faxes to cover the periodic redemption of the bonds and the semiannual interest payments during the life of the bond issue. Levies for debt service are generally made from one to two years in advance of requirements.

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In the event that bonds are authorized and not sold or are redeemed in advance of the originally scheduled maturity, taxes in future periods should be abated, both as to principal and interest requirements. The auditor should check to see that all abatement matters have been properly computed and recorded.

6. Fixed assets:

Some or many municipalities, exclusive of those operating utilities, do not maintain fixed asset funds. In view of the fact that the cost of such items had been appropriated for and paid through bond issues, tax levies, etc., the expenditures were treated as any other type of expense. This treatment appears to be in conformity with the law; however, good business practice would require fixed assets to be set up in a separate fund, so as to have proper accountability of such expenditures. This is especially true of movable assets such as automobiles, typewriters, desks, other office equipment, etc., for, without some means of control, including a periodic inventorying of such assets, improper use or loss of municipal property could occur. In addition, adequate records of fixed assets would provide important information for use in:

(a) Capital improvement programming

(b) Insurance programming

(c) Property control

7. Encumbrances:

Due to the fact that all expenditures must be provided for in the appropriation ordinance applicable to a specific fiscal year, it is necessary that some method of control be established to insure that appropriations are not overspent and that provision is made for outstanding obligations. This can be accomplished through the establishment of an encumbrance system wherein obligations in the form of purchase orders, contracts, etc. are reserved against the applicable appropriation accounts.

Basically, an encumbrance merely earmarks the appropriation so that the amount encumbered can not be used for anything else until the actual expenditure has been determined and charged against the appropriation. Through such a system the unexpended balances in the various appropriation accounts can be readily determined. When the obligations are paid or set up as an actual liability they cease to be encumbrances.

The independent accountant should be well informed in the operating mechanics of the encumbrance system and in addition should be familiar with the development, adoption and use of appropriation ordinances.

The foregoing highlights are indicative only of the special nature of certain phases of municipal accounting and auditing and, in a limited way, suggest the need for careful review of the various aspects involved in the audit of the records of an Illinois municipality.

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