This is an outline of my presentation to the Nassau Chapter of the New York State Society of CPAs. The presentation draws heavily from the Audit Guide for Employee Benefit Plans (AICPA). I prepared this outline quite a few years ago, and much has changed since then. Please consult a current copy of the Audit Guide. No one should perform audits of employee benefit plans without understanding that publication thoroughly.
(I've done ERISA benefit plan audits all over the northeast, from Boston to Buffalo, and quite a few in NYC and on Long Island, mostly multiemployer plans in the construction trades. Call me if I can be of service, I am happy to help.)
PENSION PLANS - ACCOUNTING, AUDITING, AND ERISA CONSIDERATIONS
A. Current Guidance:
FASB 35 - Accounting and Reporting by Defined Benefit Pension Plans
FASB 110 - Reporting by Defined Benefit Pension Plans of Investment Contracts (Contract value only if mortality risk included)
AICPA Audit and Accounting Guide - Audits of Employee Benefit Plans
ERISA and related IRS and DOL rules and regulations
FASB 105 - Disclosure of Information about Financial Instruments with Off-Balance-Sheet Risk and Financial Instruments with Concentrations of Credit Risk
SOP 88-2 - Illustrative Auditor's Reports on Financial Statements of Employee Benefit Plans Comporting With Statement No. 58, Reports on Audited Financial Statements
SOP 92-6 - Accounting and Reporting by Health and Welfare Benefit Plans
SOP 94-4 - Reporting of Investment Contracts by H & W and DC Pension Plans
B. The Plan
Defined Benefit Pension Plan: Promises to pay participants' benefits that are determinable based on factors such as years of service, age, and compensation.
Defined Contribution Pension Plan: Maintains individual account for each participant and provides benefits based on amounts contributed for a participant, investment experience of such accounts, and forfeitures allocated to such account. Includes profit sharing, money purchase, stock bonus and employee stock ownership, and thrift type plans.
Health and Welfare Plans: Provide participants with benefits such as medical, dental, unemployment, disability, vacation, apprenticeship, scholarship, and legal services.
C. Government Regulation
Employee Retirement Income Security Act of 1974 (ERISA) - Established minimum standards for participation, vesting and funding, and imposed new restrictions and responsibilities on fiduciaries.
Pension Benefit Guaranty Corporation (PBGC) - Insures benefits of participants of defined benefit plans against loss upon plan termination, and it administers terminated plans in some cases.
Department of Labor (DOL) - Shares with the IRS the authority to prescribe reporting and disclosure requirements, administrative responsibilities, and enforcement powers.
SEC - Some defined contribution plans, such as certain stock-purchase and savings plans, are required to register and report to the SEC. Regulation S-X prescribes the form of financial statements.
D. Level of Service - Audit Required? Full or Limited Scope?
Generally, plans with more than 100 participants at the beginning of the year are required to be audited.
Exceptions:
80/120 rule: Plans with between 80 and 120 participants at the beginning of the plan year may elect to file the same form as filed in the previous year. If, under this rule, a plan with more than 100 participants elects to file a 5500-SF, no audit is required. (Exceptions: small plans with less than 95% qualifying assets, and certain welfare plans, might still be required to be audited.)
Certain insured plans need not be audited, if benefits are fully guaranteed by the insurance company and certain other conditions are met.
Limited Scope Exception:
DOL regulations state that a plan whose assets are held by a "regulated" bank or insurance carrier is not required to have its auditor extend his examination to any statements or information prepared by that institution and certified as complete and accurate by that institution. Note that this limited scope examination is subject to all of the guidance in the Audit Guide except for procedures relating to the audit of investments to the extent those investments are held by, and certified by, the institution.
Independence: DOL's rules are more restrictive than AICPA's. Under DOL Reg 2509.75-9, accountant will not be considered independent if he or a member of his firm maintains financial records for the employee benefit plan.
E. Planning the Audit
1. SAS 55 - Consideration of the Internal Control Structure in a Financial Statement Audit, requires the auditor to obtain a sufficient understanding of an entity's internal control structure (control environment, accounting system, and control procedures) to plan the audit. The auditor should document the understanding in the workpapers.
When the plan's investments are held by a trustee/custodian who exercises discretionary authority (ie, initiates transactions), the auditor must obtain an understanding of the internal control structure of the trustee/custodian.
If the auditor decides to assess control risk at less than maximum, he will need to obtain evidence of the operating effectiveness of those policies and procedures.
2. Planning Materiality - For most plans it does not make sense to measure planning materiality in relation to "net income". For a pension plan, materiality might be measured in relation to net assets available for benefits; for a welfare plan, total revenues might be a more appropriate measure.
3. Other Guidance:
FASB 53 - Auditors Responsibility to Detect and Report Errors and Irregularities: The auditor should exercise (a) due care in planning, performing, and evaluating the results of audit procedures, and (b) the proper degree of professional skepticism, to achieve reasonable assurance that material errors or irregularities will be detected.
FASB 54 - Illegal Acts: Does not impose any special responsibility to detect violations of ERISA. At a minimum, however, auditor should make inquiry and request management representations regarding compliance with ERISA.
4. Suggested Planning Procedures
Read:
Plan Document, including amendments
Minutes
Prior financial statements
Actuary's report(s)
Exemption letter
IRS/DOL correspondence
Agreements with Custodian, Investment Manager, etc.
Determine custody and location of investments, nature of any safekeeping arrangements, in what name are securities held?
Determine custody and location of investments, nature of any safekeeping arrangements, in what name are securities held?
Determine investment authority and guidelines
Who maintains data (sponsor, bank, insurance co., other)
What type of plan is it? Single or multi-employer, funded or unfunded, insured, contributory or not?
Determine the extent of involvement of actuary and other specialists.
F. Investments
1. Objectives:
a) To determine whether all investments are recorded and exist.
b) To determine whether investments are owned by the plan and are free of liens or security interests.
c) To determine whether transactions are recorded and investments are properly valued in accordance with GAAP.
d) For investments in insurance contracts, to determine whether the terms of the contract are being complied with and are properly disclosed in the plan's financial statements.
2. Auditing Procedures include:
a) Analysis of changes in investments during the period.
b) Evidence regarding existence and ownership, and information regarding liens, security interest, etc.
- Count securities on hand
- Confirm securities in safekeeping
- Review minutes, agreements, confirmations for evidence of liens, etc.
- Confirm with brokers for securities in transit.
- For investments in common trust funds, confirm units of ownership, and review audited financial statements of the common trust for reasonableness of per-unit data and evaluation of fair value. If not audited, seek third-party audit report, or consider additional procedures.
- Insurance investments can generally be confirmed; income and fees can be tested to contract terms or reviewed for reasonableness. Consider financial strength of insurance company.
- Examine deeds, closing documents, tax bills, etc. to support real estate investments; consider title search; test related income and expenses.
- Confirm loans and mortgages, review file documentation, test interest received and accrued; evaluate collectability of loan by review of payment history, quality of collateral, and other available data. Evaluate fair value by comparison of yield to available market rates, considering the degree of risk associated with the investment.
c) Test transactions for authorization and agreement to brokers' advises.
d) Test computation of gains and losses.
e) Test completeness of income recorded, and test computation of accrued income receivable.
f) Test valuation of investments: In most cases, investment are to be valued at fair value. The financials will disclose separately investments whose fair value was determined by quoted prices in active markets, and those whose value was determined in good faith by the plan's board of trustees. The auditor evaluates the plan's methods of determining fair value, tests the application of those methods, tests the underlying documentation, and considers the guidance in SAS 73 (Using the Work of a Specialist) if applicable.
Valuation of Insurance Contracts:
Form 5500 permits unallocated insurance contracts to be reported at either current value or "as determined on Schedule A" (contract value).
GAAP requires insurance contracts to be reported consistent with Form 5500. For a long time, accountants treated all contracts with insurance companies as "insurance contracts", including many contracts that were in reality investment contracts.
FAS 110 clarified reporting for DB pension plans: Insurance contracts include a transfer of risk. Investment contracts are to be reported at fair value, and insurance contracts are to reported consistent with Form 5500.
SOP 94-4 clarified reporting for health & welfare plans and for dc pension plans.
a. DB welfare (and pension) plans: report investment contracts at fair value.
b. DC plans:
"fully benefit responsive" investment contracts at contract value
all other investment contracts at fair value
insurance contracts at 5500 value
Benefit responsiveness is the extent to which a contract's terms permit and require withdrawals at contract value for benefit payments, loans, or transfers to other investment options offered to the participant."Fully benefit responsive" means that the contract and plan allow participants reasonable access to their funds at full contract value, with no conditions, limits or restrictions. However, plans that allow inactive participants reasonable access can impose restrictions on active participants consistent with plan objectives.
g) Review investments for increased disclosure requirements imposed by FASB 105 and 119: concentrations, off balance sheet risk, and derivatives.
h) Review plan investments for compliance with restrictions or limitations imposed by the plan document or guidance provided by the trustees. Consider whether the plan's investments violate regulations regarding transactions with "parties at interest". Consider whether investments (or concentrations of investments) violate ERISA prudent man requirements to diversify investments and minimize risk. These concerns apply to all investments in real estate, loans and mortgages.
3. Confirmation of Investments
In many cases a plan will delegate certain investment responsibilities to a trustee (custodian), investment advisor, or both. The auditor's procedures can vary considerably depending on the nature of the trustee arrangement and the physical location and control of the plan's investments.
a) Directed Trust: A trustee acts as custodian of the plan's investments and is responsible for collecting investment income and handling trust asset transaction as directed by the party having discretion to make investment decisions.
b) Discretionary Trust: A trustee has discretionary authority and control over investments and is authorized by the plan or its investment committee to make investment decisions.
A trustee/custodian, such as a bank trust department, is legally responsible for investments under its control. The auditor can generally accept a bank trust department's confirmation of investments as evidence of existence and ownership of investments. However, the auditor should obtain evidence regarding the trustee's responsibility and financial capability. Procedures to consider:
- Read agreement with trustee defining responsibilities.
- Determine extent of trustee's insurance covering plan investments.
- Read financial statements of trustee.
When assets are held in a discretionary trust, additional procedures should be considered because the plan will not have independent records of investment transactions and therefore can not maintain control over investments.
SAS 55 applies; obtain an understanding of control structure of the trustee:
i) Obtain single-auditor report on trust department controls (Consider reputation and independence of single auditor).
ii) If no single auditor report is available, apply appropriate procedures at the trust department.
Reporting Separate Investment Options
AccSec Practice Bulletin 12: Plans that provide for participant-directed investment programs are required to disclose amounts (net assets and components of changes in net assets) related to those individual programs, either in columnar format, footnotes, or separate financial statements.
Aggregation of options: investment funds with similar objectives may be aggregated only if each is less than 5% of total net assets; self directed accounts that select specific investments, such as individual stocks or bonds, may be aggregated and presented in on column as one fund option. Items that are aggregated should be disclosed as aggregated.
G. Plan Obligations
1. Objectives
Defined benefit plans: To determine whether the actuarial value of accumulated plan benefits, components of, and changes in, those benefits are presented in conformity with GAAP. Audit procedures center on tests of benefit payments, participants' data, and using the work of an actuary.
Defined contribution plan: To determine whether the allocation of contributions, income and expenses to individual accounts are properly computed and in accordance with the plan document, and whether the total of all participant accounts reconciles to total net assets available for benefits.
2. Audit Procedures include:
a) Using the work of an Actuary - SAS 73 applies.
- review qualifications of actuary
- Obtain understanding of actuary's assumptions, methods, and consistency of application; consider whether assumptions and funding method comply with ERISA.
- Inquire whether valuation considers significant provisions of the plan, including amendments.
- consider actuary's independence.
- compare data used by actuary to financial statement data; test census data used by actuary to participant records.
b) Tests of individual participant's accounts
- read plan document to understand provisions for the allocation of income, expenses, and forfeitures.
- test allocations.
- test crediting of employer and employee contributions to individual accounts; test allocation of funds to authorized investment vehicles.
- consider confirming participant accounts.
- reconcile total participant account data to total financial statement data, especially total participant account balances to total net assets.
H. Participants' Data
1. Objective:
a) To determine that all covered employees have been properly included in eligibility records and contribution reports.
b) To determine that participants' data was properly accumulated in plan records and reported to plan actuary.
2. Audit Procedures include:
a) Read plan document, collective bargaining agreement, etc.
b) Test payroll records to plan records of participants' earnings records. Test pay rates and computation of earnings.
c) Examine personnel files to substantiate date of birth, hire, marital status, pay rates, etc.
d) Some multiemployer plans assign a field auditor to test payroll records of participating employers; if so, review and test his procedures and findings.
e) Defined benefit plans: test the reliability of data used by the actuary in his computations by tracing data from the actuary's report to plan data.
f) Defined contribution plans: trace individuals who have terminated to benefit payout or to forfeiture records.
I. Contributions and Contributions Receivable
1. Objectives:
a) To determine whether all amounts received or receivable by the plan have been properly recorded.
b) To determine whether an appropriate allowance for doubtful accounts has been made.
2. Audit procedures include:
a) compare schedule of contributions received to a list of participating employers for completeness.
b) Test contribution rates and clerical accuracy of a sample of contribution reports. Review contribution provisions of the plan documents and test whether contributions are properly computed.
c) Reconcile total contributions per participants' records to contributions received per cash receipts records.
d) Test postings from contribution reports to participant records, and from participant records to contributions reports and cash receipts.
e) Confirm contributions with participating employers. For defined contribution plans, consider confirming transactions and balances with employees.
f) For defined benefit plans, when contributions are not determined by collective bargaining agreement, determine that contribution is consistent with actuary's report. Determine if contribution meets minimum funding standard requirements.
g) Review plan criteria for accruing employer and employee contributions, and determine whether accruals have been recorded in accordance with GAAP.
h) Evaluate the reasonableness of the plan's allowance for doubtful accounts.
i) Some multiemployer plans sell stamps to employers, and these fringe benefit stamps are given to employees as part of their wages. Employees receive credit for hours worked based on stamps redeemed. Audit procedures include:
- Control stamp inventory and reconcile sales to ending inventory.
- Test participants' receiving credit to redeemed/canceled stamp books.
- Liability for stamps sold but unredeemed?
J. Benefit Payments
1. Objectives
a) To determine whether payments are in accordance with plan provisions and related documents.
b) To determine whether payments are being made to or on behalf of eligible persons and only eligible persons.
c) To determine whether transactions are recorded in the proper amount, account, and period.
2. Auditing procedures include:
a) Transaction test - benefit payments. For a randomly selected sample of participants receiving benefits:
- Examine participant's file for type and amount of benefit, spousal approvals, elections of benefit form, and authorization for benefit amount (minutes, actuary, etc.). For medical claims, examine service provider invoices or other evidence of service actually rendered.
- Evaluate participant eligibility for benefit, based on accumulated hours of service, age, and earnings. Test to documentation such as birth and wedding certificates, earnings cards, etc.
- Examine beneficiary form when payment is made to someone other than the participant.
- Recompute benefit amount based on plan document, options elected, and credited service amounts.
- Compare benefit amount to amount actually disbursed.
b) Evaluate whether procedures exist to determine the continued eligibility of participants to receive benefits, to ensure that participants are promptly removed from eligibility/benefit rolls upon death, and to periodically reevaluate the continued eligibility of participants receiving benefits over a long time period.
c) Evaluate client's procedure for investigating long-outstanding benefit checks.
d) If benefits are paid from participants' individual accounts, test that disbursed benefits are properly reflected in individual accounts.
e) Consider comparing endorsements on canceled checks to participants' files, confirming benefits payments directly with participants or service providers.
f) In some circumstances, benefit disbursements are determined or made by a third party such as a bank or an insurance company. In this case the auditor may need to obtain an understanding of the internal control procedures of the third party. This can be done by obtaining a special-purpose report in accordance with SAS 70, Reports on Processing of Transactions by Service Organizations, or by applying appropriate procedures to the third party administrator. The use of the third party's independent or internal auditors to perform these procedures may be appropriate.
K. Tax Status
1. Internal Revenue Code - When an employee benefit plan and its underlying trust qualify under the Code, certain benefits are available:
a) Contributions by plan sponsor are deductible currently, subject to certain limitations.
b) Participants are not taxed until benefits are distributed or otherwise made available.
c) Trust is exempt from income taxes, except tax on unrelated business income.
d) Distributions can qualify for favorable tax treatment, such as rollover, forward averaging.
2. A plan can lose its qualification; results can be disastrous. Audit procedures should include:
a) Review IRS determination letter or opinion letter from plan's legal counsel. If plan has been amended, review any new rulings issued by the IRS regarding the amended plan. If plan has not been amended recently, consider whether it should have been, to adopt changes required by new laws or regulations.
b) Become aware of applicable rules and regulations regarding prohibited transactions, nondiscrimination, limits on plan benefits. In evaluating the results of audit procedures in other areas, be alert to matters that could affect qualification of the plan.
c) Read the minutes.
d) Inquire about, and review, correspondence from IRS and DOL.
e) Request that the plan's attorney identify any situations that could affect qualification. (Some attorneys will not respond to this question)
f) Inquire of plan administrator about any plan activities that could cause the plan to lose its exempt status. Include in management's representation letter.
g) Consider requesting attorney (or actuary) to confirm that the plan has been timely amended as required by law and continues to be a qualified plan in form and operation.
L. Party in Interest Transactions
1. ERISA defines a "party-in-interest" to include fiduciaries and employees of a plan, any person who provides services to the plan, an employer whose employees are covered by the plan, an employee organization whose members are covered, a person who owns 50% of any such employer or employee organization, or relatives of any of the above. FASB 57 definition of "related parties" includes substantially similar concepts.
2. Certain transactions with parties in interest are prohibited transactions under Section 406(a) of ERISA. See Audit Guide Chapter 11 and Appendix A for more details.
M. Other Matters
1. Form 5500 Penalty for failure to comply with reporting requirements, $1,000 per day.
2. Edit Testing of Form 5500.
3. FDIC Coverage.
4. Compliance Matters:
· Information Reports: 1099's, etc.
· Disclosures to participants
N. IRS and DOL AUDITS
IRS and DOL share responsibility for enforcement of ERISA provisions. IRS bears primary responsibility for matters relating to qualification matters, minimum participation, vesting, and funding standards; DOL bears primary responsibility for matters relating to fiduciary conduct and prohibited transactions.
ERISA authorizes DOL to prescribe regulations necessary to carrying out ERISA's non-tax provisions, and DOL is charged with investigating violations of all non-tax aspects of ERISA.
Fiduciaries are required to discharge their duties solely in the interests of the plan participants and for the exclusive purpose of providing benefits and defraying reasonable plan expenses. This requires fiduciaries to exercise the skill, prudence and diligence of a prudent man, 2) in accordance with plan documents and instruments, and 3) to diversify plan investments to minimize risk of loss.
Violation of Fiduciary Duty:
- "prudent man" investing
- concentration of investments
- denial of benefits and appeal procedures
- pursuit of delinquent contributions
A fiduciary is liable to the plan for any losses resulting from a breech of fiduciary responsibility, as well as his profits from misuse of plan assets; a civil penalty of 20% of amounts recovered is imposed on the fiduciary.
DOL doesn't do "audits", it conducts "investigations". Don't expect the investigators to be accountants; most often, they're attorneys.
DOL generally targets plans which appear to have the highest potential for abuse, using office reviews of Form 5500, corporate annual reports, public records, and other sources. IRS referrals and participant complaints are often the trigger for an audit. DOL investigators are instructed to be alert for evidence of age, sex, or race discrimination, for possible referral to EEOC.
O. WHAT'S HOT
PWBA Assessment of Audit Quality:
A 1989 study found numerous audits that failed to comply with professional standards. In 1995 DOL conducted a new study, with similar results. DOL suggested these audit deficiencies resulted from inadequate training of auditors conducting plan audits, auditors whose practice did not include many audits, a lack of awareness by auditors of the uniqueness of EB plan audits, and the failure of auditors to understand the limited scope exception.
PWBA has established an ongoing quality review program; auditors deemed by PWBA to have performed substandard work are referred to state licensing boards or to the AICPA Professional Ethics Division. Through 1995, over 300 such referrals have been made.
In addition, PWBA continues its aggressive reporting compliance program; through 1995, it has rejected over 4,200 filings and imposed over $64 million in civil penalties. Another 590 late or non-filers have been assessed over $49 million in late/non-filing fees.
Benefit Distribution Annuities
Annuities purchased to settle plan liabilities: especially in the wake of insurance company failures (Executive Life, etc), DOL takes the position that the selection of annuity provider is a fiduciary act that requires the selection of the SAFEST AVAILABLE annuity provider. Prudence requires that fiduciaries conduct an objective, analytical search, evaluating creditworthiness, quality and diversity of investment portfolio, size of provider relative to proposed contract, level of provider's capital and surplus, lines of business, use of guarantees or separate accounts, etc. Reliance solely on insurance rating services would NOT satisfy this requirement.
Plan Investment in Derivatives
In March 1996 DOL stressed the fiduciary duty implications regarding investment in derivatives: fiduciaries are required to evaluate various risks, to consider how the derivative fits with the plan's investment policy, what role derivative play's in the portfolio, and the plan's potential for loss. Characteristics of derivatives include extreme price volatility, a high degree of leverage, limited testing by markets, and difficulty in determining market value due to illiquid market conditions. Fiduciaries who invest in derivative must secure sufficient information to understand the investment and evaluate the risks.
Participant Directed 401(k)s
1. By complying with regs under 404(c), plan sponsor can avoid fiduciary responsibility for losses resulting from participant's exercise of control. Compliance involves offering variety of investment vehicles meeting different investment objectives and bearing different risk characteristics.
2. 404(c) protection is easily lost if sponsor assumes too much responsibility, so sponsors were reluctant to educate their participants, even though it is commonly recognized that participants are in dire need of education. In January 1996 DOL issued "Interpretive Bulletin Relating to Participant Investment Education", clarifying the difference between nonfiduciary education and fiduciary investment advice. Bulletin lists four categories that constitute education rather than advice:
· Plan information
· General financial and investment information
· Asset allocation models
· Interactive investment materials
Participant Contributions
DOL is very concerned that participant contributions are being diverted for other purposes, and is proposing rules to cut down the period of time an employer can hold participant funds. Current rules require that funds be deposited to the plan as soon as possible, but in no event longer than 90 days. DOL's proposal that deposit be required to follow timing of payroll tax deposits will probably not stick, but a 15-30 day requirement is likely. Late remittance is a prohibited transaction requiring supplemental schedule disclosure. [update: final rule requires that funds be deposited as soon as it is practical to segregate, but in no event later than the 15th day of the month following the month the funds were withheld.]
Plan Loans
IRS issued proposed regs addressing plan loans, deemed distributions vs. offsets, grace periods, etc. Since an offset may be an impermissible distribution affecting plan qualification, auditor needs to be familiar with these rules.
401(k)s Targeted
IRS recently identified 550 401(k) plans for detailed review of ADP and ACP testing, distributions and allocation of investment income.
