Audit week can be one of the most stressful times of the year for city management. In this episode, we talk to Doug Martella of Go Virtual CFO about his experience auditing cities, and what aspiring city managers should know about the audit process. We'll even tease out a secret your auditors probably don't want you to know. This is ZacCast, episode six. Here we go. Hey, Patrick.

Hey, Chad. What's up?

Got Doug Martella back in studio. Doug, how you doing?

Good. Good, guys. Thanks for having me.

Oh, you're welcome, Doug. We are so happy to have the Canadian friend here today.

So Doug was here on our single local tax rate episode. We didn't really get a whole lot of time to talk to you about who you are and what makes you so Canadian, so why don't you, uh, give us a little background about yourself, sir?

Yeah, um, uh, I'm the owner of a, a small company, uh, Go Virtual CFO. I do help a lot of, uh, small governments, uh, with their finances. Some, some governments that can't afford a full-time, high-quality professionals, maybe out in rural areas, where I can, uh, get in there and, and help them with their finances.

So if you hate your bank reconciliation, call Doug.

You got it.

Yeah, right on.

Basically, right there.

That's the easiest way to say it to a city manager.

If you hate preparing for your audit, just, just give me a call.

Give Doug a call.

Yeah.

So a city maybe 2,000, 5,000 or less, do they really need... And I'm not trying to, like, throw up a softball for you for a sales pitch, but do they really need a full-time finance director?

I think you definitely have to have an open-minded, um, city manager, someone that's gonna kinda think outside the box to offer those services outside the organization. Traditionally, it's been in-house, right? Your accounts payable, a check has gotta be written in the house, deposits gotta be made there, but these days, it's so remote. I mean, you could do that-

I guess the-

You could do that remotely

... the challenge is, though, that the skills that you need for at the high-level accounting or finance director, CFO level, are really kinda overqualified for some of the other roles that you have to be able to perform in a small city. Um, just because it's not gonna fill up your full plate, right? So you're gonna be wearing multiple hats, and that's kinda the challenge, and I think that's where you can provide a lot of value, is providing the professional financial help at a cost that allows them to bring someone who has maybe better customer service skills or better whatever else that they happen to need. 'Cause it's difficult to find someone, I think you're a rare exception, Doug, who has a-

Thanks, Chad

... financial mind but k- is also personable and can do well with residents and, you know, customer service side.

I definitely think that's difficult when you, when you have someone, like, writing checks or, or making deposits, and then all of a sudden they gotta know about a new lease standard that comes out or, or something like that, some, some GASB introduction that they may not even know that they gotta get ready for the audit, and, and they're just- they're writing AP and, and basically hired as a clerk.

And that stuff is written for accountants and people with that kind of financial background-

Correct

... to understand exactly what they're asking for. So yeah, someone who doesn't have that background, it's gonna take them a while to understand what's going on.

Yes. Small city managers have to make a choice, right? We either hire somebody who we try to stretch up, or we hire somebody that we try to stretch down. So we hire somebody who's more of a clerk, that we then say, "Hey, we need you to do some of these accounting roles," and hopefully we don't get ourselves in trouble, right? Or we hire somebody on the, on the top end, who's extremely qualified, and we're probably overpaying for what we need, and then we ask them to speak to residents about water bills, right? That's... Y- you have to go one way or the other. The benefit of outsourcing is you don't. You can have the best of both worlds. You can have that customer service in-house, uh, and you can pay what it actually costs you to provide that, and you can have that expertise on the outside, outside of your typical auditors, that are doing those financial reports and reporting and, you know, 941s and bank reconciliations and all the things that city managers just don't like to hear. We don't like to do any of that.

But speaking of auditors, Doug-

Used to be one.

You used to be one!

Used to be one.

Yeah.

Yes.

Seven years.

Seven years-

Yeah

... auditing local governments.

Yeah.

What we wanna talk to you about today, Doug, is for those aspiring managers, for people who are coming up in their career, who have looked at an audit, but it's made their eyes glaze over, let's talk about some of the things that, uh, that the audit is good for, some things that, uh, you might not know or would be helpful to know as a, as a future manager. Just from your s- unique background as a former auditor turned over to the good side, working for the city itself.

Right. Um, definitely when I, when I was an auditor, I, I did see a lot of, a lot of nerves, a lot of scared, um, management people, a- and that's the truth. That was from one client to the next. Um, they were all kinda generally nervous when we came in about what, what's gonna, what's gonna happen.

It's the worst week of the year.

Apparently so, uh-

For some cities, it's two weeks.

Yeah.

Yes. Depends how many journal entries you gotta catch up.

Depends, yeah.

Yeah.

Yeah.

But just getting ready for it, like mentally and emotionally, and then physically with all the documentation, um, it is... It's extremely stressful. It happens to occur usually during this holiday period, um, which also kinda sucks because your mind's... You've g- you've got your budget, you know, you're putting together your document, but now you gotta get ready for audit, and you got someone coming over there and looking over your shoulder at everything that you've been doing for the past 12 months.

And you're thinking, "Did I do it right?" Basically, the whole time.

Mm-hmm.

And I, I think that's probably one of the bigger misconceptions, though, is an auditor comes in trying to help you, trying to help get everything right, not necessarily trying to look over your shoulder, trying to, trying to get you on something. It's actually trying to help you learn, make sure we get it right next time, and that-

So you don't, you don't take pride in that management letter that you write at the end of the day?

No, not at all.

Yeah.

Not at all, 'cause, 'cause generally that could, that could lose a client at the end of the day.

Yes.

So-

Probably so, yeah.

So no, it's more, more of helping, helping the manager-

Okay

... get everything in order.

Okay.

Um, that's probably one of the bigger misconceptions when auditors do come in.

... yeah. So I believe you because I know that you don't lie, but being on the other end of it, it doesn't feel that way a lot of times.

No, I mean, especially when they ask you the question, it's always so cold, too. They're like, "Hey, I need you to give me the documentation on this item." It's very robotic.

Sometimes you don't get very personal people.

No, sometimes the, the people aren't very friendly. You know, we, we joke around in our office. We try to get our auditors to smile, you know? So but realistically, I mean, they come across as kind of cold and-

And every-

Correct

... every time they ask you a question, the thought in your head is, "Oh, God, what did I do now?"

You feel attacked.

Y- well, you do, just partly because, no offense, but a lot of auditors, they're doing a lot of cities, right?

Mm-hmm.

So it's a process. You have to go through the steps, get the documentation. It's not like they're having a ton of fun. They're not out there for their personal enjoyment, even if they like the work, right? You have steps that you have to do to get this thing done. So when they come into your office, and they say, "Hey, uh, can you talk to me about this?" Like, that's just the next thing that they have on their checklist, right? But for you, it's like, "Oh, no." "What did I do?"

It's a bit robotic. How many cities did you do a year?

Probably 30 to 40 cities of-

I, I-

... audit work

You literally do the same process 30 to 40 times a year for seven years?

Yeah.

Yeah.

And depending on where they're-

Some big, some small. Yeah.

Depending on where they're located, you might be... Like, you may not be going home that night, right? So you may be a couple of weeks at a time out on the road, right? You know, so it's not like you're necessarily in the best state of mind, 'cause if you're traveling, if you're in a new place, um, you know, y- you're more focused on just getting the job done than making a bunch of friends.

Right. Maybe, maybe that's why they're- the auditors can be so cold sometimes, 'cause they've just been on the road for a little while.

Yes.

It's time.

So if they're r- they're really just trying to help you get it right next time, even if you messed up this time. A lot of times, in my experience, uh, you do end up in a situation where you're, you're kind of arguing or debating about why you did something the way that you did, or why it should be recorded a different way. One particular example that we dealt with recently, um, and I'm sure affects a lot of cities, especially small cities or anyone who's doing a joint project-

Mm-hmm

... with TxDOT, with some other regional partner, is if you're sharing capital costs. Like, say, you're, you're working on a TxDOT project, and you're paying for engineering for that project, and TxDOT's building the actual, you know, road, or maybe you're contributing to part of the actual road construction as well. This question of who... What can get capitalized, what asset do you actually have? If you're paying for the engineering, and then they're building a bridge, do you actually have a tangible asset as a city that can balance the liability that you've taken out for that debt or, or for the expense that you've made?

It's just a, a complicated question that we got into, uh, when we went through the process. I, I know there's certain parts of projects where you gotta identify what asset you're actually owning, and then, and then the part after is, when the project's done, uh, who maintains the project? Who, who maintains the bridge? Um, there's just so many variables in a, in a joint project like that, which go all over the state of Texas. Um, we consulted with a few people when we, we were arguing our point here, that, uh, they account for it the same way, and they really don't care how the state accounts for it. If I'm contributing to the asset, it's, it's an asset. It's not a... It's not an expense, and I don't hold this debt for 20 years on no asset. So i- it's kind of a complicated-

Yes

... complicated question.

And that matters because?

Well, it could-

Explain exactly why that matters.

Well, if, if you expense something, let's say $300,000 in one year, um... I guess probably a better example, uh, uh, $1.5 million in one year, you expense it 'cause you paid engineering towards the project, well, you're holding debt for 20 years-

Mm-hmm

... on this $1.5 million. So you're paying interest, you're paying all this expense for the next 20 years, and you have no, no asset to offset that. So-

It turns your books upside down.

It turns your books upside down.

Yes.

Basically, you got a, you got a huge liability with, with no asset, and it just makes it- it makes the financial picture look ugly.

Now, on engineering, this may not be that big of a deal because, you know, your TxDOTs or whatever, they're not gonna be capitalizing the engineering costs they didn't have. But if you have shared project costs-

You have an AFA, an advanced funding agreement.

Right, and you're paying, say, 40% of the actual bridge or road or whatever it is that's being constructed, but that money goes... You're paying that money to TxDOT. So TxDOT is footing the bill for the full project, but you have contributed to it. They're capitalizing the full cost of the project. If you're capitalizing it, too, that keeps your books level, but it also means that there's- you're double-counting assets across the state.

Everywhere.

Everywhere.

Everywhere.

Yes.

And I think we learned that when we started talking to other, other cities about this issue, is that there's appears to be a lot of double-counting going on.

Yes.

Which we have not yet gotten into strong towns, but we will at some point. But it's its own question about whether, whether a new road should actually be capitalized as an asset or a liability. If you spend a million dollars on a new road, it's not- is it really worth a million dollars? It's just some asphalt and some grade, right?

Correct.

Uh, and all you really have is a liability 20 years from now to replace it, let alone the ongoing maintenance just to keep it in, keep it in place. So the way that we typically handle that is, you book your million-dollar asset, and then it depreciates over time until it gets to zero. But at that point, you don't really have zero asset, you have a negative million dollars, plus whatever that inflationary cost has been, liability to replace it. So not, not just that we have double-counted assets across the state or across the, the whole country, but we're actually counting things as a- as assets that probably should really be treated as liabilities.

Yeah, absolutely. And, and we have to sit there and-... go through and look at what the cost of that is going to be in the long run. So, I mean, how much is that road gonna cost us at the point of replacement? And why are we considering that to be an asset when we know it's gonna be a cost?

So Doug, so you've gone through the process, you've tried to make your auditor smile, uh, or laugh, you know, or be a little bit more personable. You get your document. Who's actually reading this thing?

I, I think that's, that's important for, for management to understand is, is really your, you know, your bond, bond people, your bond rating agencies are reading it. Um, rarely does the public really look at it and understand what's going on. It's a complicated document. Um, not saying that people out there... You know, they, they understand, can look at the basics and understand where, where a city is financially, but bond rating agencies, um, are really important for your financial report or your CAFR, whichever one you're, you're actually preparing. Um, I would tend- you know, that's something we're gonna go into a little bit, but, but why, why you should prepare a CAFR more than an annual financial report i- is for the bond rating. They put a little bit more, um, emphasis on, on a CAFR.

There's some extra points-

Extra

... if you understand that process.

Extra points.

Yes.

Um, more statistical sections for the public to understand what's going on with the city, how many assets they own, how many miles of road you got, how many miles of, of water pipe you got. Um, it's just kinda neat stuff that the public really gets to look at, and also, um, the bond, bond rating agencies put a little more points to it.

Yep.

So-

I'll tell you my biggest, um, issue with, with CAFRs is that the same information is presented, like, 15 different ways in different breakdowns. So-

Better than, better than 50 different ways for a budget?

Just-

Just, just 15?

Yeah.

That's correct.

Well, but see, I, I don't even, uh, I, I don't really accept that premise- ... because, yeah, at, at- with a budget, you have a top-level number, which is your revenue and expenses or vice versa.

Budget versus finance.

Ding, ding.

Yes.

Um, when you're looking at historical information in a budget, it's actuals, and it's, it's all the stuff that people can understand, 'cause it's not the accounting side, the liabilities and the assets. It's just the expenses and revenues, um, and then the available cash at the top level. All of the details in the audit are sort of summed up in your budget to get you your starting point, how much you spent, how much you made, how much you brought in, and then what you're left with. So yeah, you may break down that, uh, you know, your... h- here's your top-level revenue number, and then here's it broken down by taxes, by fees, by service charges, things like that. So yeah, you, you can look at the same information in a vari- variety of ways, but they almost always foot to the same top-level number. In a lot of the different schedules in your audit, they don't always foot to the exact same number, and you have to know which ones need to be added up or, uh, subtracted to, to make them match from one page to the next. And like, when we're just trying to calculate what our actual fund balance is for a budget standpoint-

Starting fund balance-

Starting fund balance

... is always a fun thing.

Can be difficult.

Yeah, there's, like, a 15-step process to say, "You look on this schedule, on this line, add that with this, subtract that, and then this is how we're gonna calculate it." And it has to be really well documented, because you need to be able to go back in prior years and recalculate it and make sure that everything is still matching for your budget document. But there are a, just a lot of different ways to look at that information. So, like, what are the most important things for, uh, if there's not a, a public financial report, like, for citizen consumption, what are some of the most important things that you would look at?

As far as, like, looking at a CAFR?

Mm-hmm.

Um-

As a layperson.

Definitely, definitely start at that general fund financial page a- and take a look at what that fund balance is, what the cash position is. Um, that'll give you a good indication of how, how they're performing. I've, I've had the luxury of working in a big city as well, um, College Station.

Yep.

Shout-out to College Station there. So, you know, looking at a cash position may not be as important there because it's, it's just astronomical amounts. Um, that I would primarily flip to, like, a, a general fund budget, line item, uh, budget-to-actual page.

Well, it's important to understand, a general fund doesn't... Cash balance in a general fund does not include debt, right?

Right.

Whereas in enterprise funds, it, it does.

Right.

So you have to back out all the debt for the projects before you actually understand how much cash is there. So the general fund, it's, you can turn into your CAFR page, to your general fund statement, and you can figure out how much money you actually have on hand. Enterprise fund, good luck.

I- it's a little more complicated.

Yeah.

You definitely have to go to the cash flow-

Yes

... statement on the enterprise fund to see where, what cash came in and what cash came out.

Yeah.

And then to understand that, you know, I, I'm not sure that's in the whole city management training-

No

... deal.

I, I don't believe that was ever taught to us in an MPA course.

But your enterprise fund's also gonna have your assets as part of your cash balance. So it has your, it has your debt and all those liabilities, but it also has all the assets, too, correct?

Yeah, it has your, your water system-

Right

... and all that stuff, yes.

Correct. Whereas your general fund has none of that on its cash side.

Yes, correct. So in general fund, you would look at cash. Do you look at, uh, do you look at increase or decrease in cash to look at, like, the change in position year over year?

Um, that, that would definitely flip to page two, where you look at the-

Okay

... the change in position, just to kinda see what they're doing, uh, how they're doing it. And then if, if you go to the budget page, you'll kinda see, did they plan for a loss? Did they plan for a gain?

Mm-hmm.

How'd they do comparative to what they planned for?

Right.

'Cause you can budget for planned use of fund balance.

Ex- exactly, right.

So if you expect to use half a million in fund balance, it's not a huge deal if you did use a half a million, depending on your policies and what your thresholds and requirements are. But if you planned for it and you followed through with it, that's one thing. If you didn't plan for it and you had a huge decrease, then that's a different thing.

It's something the public can definitely look at and, and find out pretty quick. Did you plan for it? How'd you use it?

So let's say I'm a city manager that's looking for a job, right? I'm looking at a city. What else would I be looking at in the CAFR to understand what I'm about to walk into?

It's a good question, Patrick. Um, let's see. I know when I, when I interviewed for a couple jobs, um-... you know, I generally looked at the same stuff.

Mm-hmm.

Um, I'd looked at the general fund. I, I looked at the notes, financial statements, to try to understand how much debt they had.

Okay.

Um, that's something to look forward to. You know, if you're, if you're walking in a new job, how much debt, uh, what's the payoff on that debt? Like, how much, how much money are you gonna use every year just to pay down debt that somebody else took out-

Okay

... when you're, when you're not coming, when you weren't there before?

Are you ever concerned about payables or receivables or anything like that?

Typically not, unless it's rather large.

Okay.

Um, yeah, I know we had maybe a situation, um, before where we had a large payable-

Mm-hmm

... to another city that, you know, if a new manager walked in, they'd probably ask a lot of questions on that, um-

Okay

... just to kinda see what it is. But generally, a, a good way to, good way to start is, is the debt, see what you're looking at-

And now-

in long term.

Now, with GASB requirements, you have to list all of your incentive agreements in there as well, right?

Yeah, correct. Um-

Okay, so you can find that in the notes section?

You can find that in the notes section.

Okay.

Um, some people will have payables for that-

Okay

... um, based on the reimbursement agreements and some different type of 380 agreements.

So a lot of city managers walk into situations where they don't really know what they've committed themselves to, right? Or the city has committed themselves to. Now, you can look at the CAFR, and you can see specifically what the city's committed to any government development agreements.

I agree, yeah.

Okay.

Yeah, agree.

There's-

It'll be back.

Interesting side note as it relates to Zach Tax and confidential information, if you have an incentive agreement with a single taxp- or single business reimbursing sales taxes, you can pretty well back into the amount of sales tax they're generating?

That's correct, if you just had one business.

Which is interesting side note.

Yes.

Um, how much time and effort are you spending as an auditor on some of your smaller governmental funds, your park dedications, maybe your police seizure funds, your court technology funds? 'Cause those wrap up into your governmental funds, which is included in general fund, but typically they're significantly smaller. They don't have a lot of activity going on.

Is this where you wanna talk about materiality and, and what an auditor looks at?

Not yet- ... 'cause that still kinda, that still kinda gets at me.

Okay.

Might save it for just a minute.

Um, generally, if there's, if there's not a lot of activity at all, or if there's, you know, hardly any activity from year to year, um, and it's a small balance, the auditor's typically not gonna put much time into it. Um, that's where that materiality conversation comes in, is: What thresholds do we use on what funds? And then, and then kind of attack those and see what, see what's going on with those funds above that threshold.

S- so theoretically, you could have a small non-operating fund, like a special revenue fund, that's so small that basically it's not even material?

Correct. Yeah.

Okay. Okay, let's talk about materiality then, because... So I came from the budget world, never really had to do an audit. The first time I had to do an audit, we were stressing over the tiniest, tiniest dollar amounts, like pennies. We were, we were trying to make sure everything matched and footed and was properly accounted for. So Doug walks in as our auditor, and I find out something very interesting, which is that depending on, like what Doug just said, depending on the size of the fund and what type of fund it is, your auditors are going to have a materiality threshold below which they're not super concerned about getting 100% accuracy.

Right. It's, it's not like we're not concerned with, with plugging numbers or something like that.

Mm-hmm.

But generally speaking, um, if you have a couple of, you know, miscellaneous accounts that have a few hundred dollars in them, um, in order-

Or even a few thousand or-

Even a few thousand -

... tens of thousands

... depending on how, how large the government is. Um, I know in College Station, the materiality was significantly higher than, than I ever experienced, uh, dealing with small governments. But, um, yeah, it's tough to, tough to put that in context, that $100,000 may not matter in the materiality scheme of things in your whole CAFR report.

So in other words, if you were working on your bank recs, and you can't find that $50 deposit, don't spend $150 in staff time trying to figure out exactly where it is. Just stick it in the miscellaneous revenue and go on about your day.

And go on about your day, and then, and then kinda note it. Make sure you know, "I did that," and then move on to the next thing.

So in a city of- with a $3.5 million general fund, what is that threshold?

It's an interesting number that you picked there, but-

Yes. Just curious.

Um, it could be anywhere from 5 to 10.

Okay.

5, $10,000.

Okay. So it's-

On any single transaction or cumulative?

Any single, single transaction, um, or-

If you have several 5,000-

or balance

... if you have several $5,000 issues, that's gonna raise a flag. But-

Yeah

... if you got one or two that are maybe 1,500 bucks, it's probably gonna, gonna be checked off as okay.

Right. Right, generally speaking, yeah. And, and some of the account balances, too. If you have a bunch of account balances on your revenue item, revenue list, that, uh, are $5,000, $10,000 and under, generally not gonna test anything or, or look at anything, uh, for those items.

Interesting. Okay. I, I mean, it's good information to know, 'cause I think a lot of cities freak out when an auditor walks in their office and says, "I can't find this transaction. Can you please go back and get me the documentation on this transaction?" And it may be, like, a $100 transaction, right, or a $2,000 transaction, whatever that may be. So it's, it's good information to know from a city management perspective.

Well, Doug, you have any parting thoughts for us?

Uh, great conversation today. I hope, uh, I hope new city managers and city managers that are in the business, uh, learned a little today about, about a CAFR, materiality, and, and all that we went through.

It was super nerdy.

I learned a lot about it, too.

About it.

Thanks, Nate.

Thanks for hanging out with us, Canadian friend.

Appreciate it, guys. Appreciate it for having me.

Yeah.

So if you are particularly in a smaller city, and you are looking for really high-quality, professional, financial help, check out govirtualcfo.com. Give Doug a call. Happy to help. Really good. You will not be sorry.

Thanks, guys. Appreciate it.

Absolutely. Thanks for hanging out.

We'll see you all next time.

All right, bye, guys.

Hey, everyone. Thanks for listening. Show notes for this episode available at ZacCast.com/6. If you've got something you wanna talk about, just let us know. Hit us up at cast@zachtax.com. See you next time.