Environmental Protection Agency
        Audit Guide for
 Clean Water and Drinking Water
 State Revolving Fund Programs
           Revised September 2002

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Abbreviations

The following abbreviations are often used in this guide:
ACH
AICPA

CFDA
CFR
Clean Water Act

Drinking Water Act

EPA

FASB

GAAP
GAAS
GAGAS
GAO
GASB

IUP

NCGA

OA
OIG
OMB

SAS
SRF
Automated Clearing House
American Institute of Certified Public Accountants

Catalog of Federal Domestic Assistance
Code of Federal Regulations
Title VI of the Clean Water Act of 1987

Safe Drinking Water Act Amendments of 1996

Environmental Protection Agency

Financial Accounting Standards Board

Generally Accepted Accounting  Principles
Generally Accepted Auditing Standards
Generally Accepted Government Auditing Standards
General Accounting Office
Governmental Accounting Standards Board

Intended Use Plan

National Council of Governmental Accounting

Operating Agreement
Office of Inspector General
Office of Management and Budgets

AICPA Statement of Auditing Standards
State Revolving Funds

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                                      PREFACE

This audit guide was originally issued in June 1998 as an aid to performing financial audits of the Clean
Water State Revolving Funds (hereafter referred to as SRFs) administered by states.  This guide is
intended to be used by all auditors who perform Clean Water and Drinking Water SRF financial
statement audits.

Several factors prompted the need to revise the guide.  First, the Safe Drinking Water Act Amendments
(referred to as the Drinking Water Act) of 1996 established the Drinking Water State Revolving Loan
Program. The Drinking Water program is very similar to the Clean Water program except the "set-
asides" and certain other operational aspects.  The accounting for the loan portion of the two programs
is the same.  Many states operate both programs in the same organization or department, and including
both programs in  a single document seemed logical.  The Drinking Water Act allows states to administer
their Drinking Water SRF in combination with other state loan programs, including the Clean Water SRF.
It also allows a state to transfer up to 33 percent of a  particular fiscal year's Drinking Water capitalization
grant between the Clean Water and the Drinking Water programs at the state's discretion, and assets of
both programs can jointly guarantee or secure debt issued.  These provisions linking the Clean Water
and Drinking Water SRF programs signal Congressional intent to implement and manage the two
programs in a similar manner. When possible, the annual review of each program will be performed
across both programs.  This guide includes such revisions, as necessary.  For these reasons, this guide
combines auditing and reporting of both the Clean Water and Drinking Water programs.

Second, the Governmental Accounting Standards Board (GASB) has issued a number of
pronouncements  that affect financial reporting of the states, and the SRFs. These statements are:

       !  No. 33-Accounting and Financial Reporting for Nonexchange Transactions, issued December
       1998,

       !  No. 34-Basic Financial Statements-and Management's Discussion and Analysis-for State and
       Local Governments, issued June 1999,

       !  No. 37-Basic Financial Statements-and Management's Discussion and Analysis-for State and
       Local Governments: Omnibus, issued November 2001, and

       !  No. 38-Certain Financial Statement Note Disclosures, issued November 2001.

GASB 33 and 34  have significant impacts on how state and local governments account for various
activities and report those activities in the financial statements.  GASB 33 was effective for years ending
June 30, 2001, and GASB 34 will be phased in over a three-year period beginning for fiscal years
beginning after June  15, 2001, depending on the size of the entity. Most SRF programs will be required
to implement GASB 34 for years ending June 30, 2002.  This guide is not intended to  be used as an all-
encompassing discussion on the implementation of GASB 34, but only identify how it may affect the
SRFs based upon OIG experience. GASB 37 makes several relatively minor amendments to GASB 34
that may apply to some SRFs depending upon the individual circumstances. GASB 38 establishes
disclosure criteria to add descriptions of activities accounted for in major funds, debt service disclosures,
interfund transfers and other additional disclosures.

The Office of Management and Budget (OMB) has made some  revisions to Circular A-133, Audits of
States, Local Governments, and Non-Profit Organizations, and the associated compliance supplement
requires that suggested report formats be modified to conform to the revised guidelines.

Lastly, this revised audit guide includes additional sample financial statement formats that were not
included in the original version. The new sample financial statements include suggested formats for

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direct loan programs, leveraged programs, combined Clean Water SRF and Drinking Water SRF
programs, and reporting of administrative funds and administrative fee income issues.  In addition,
different formats for the report on internal controls and compliance are included.

This guide is intended to identify accounting, financial reporting, and Federal compliance guidance that
is applicable to the SRF programs. However, it is only a guide. Nothing is intended to replace the
auditor's judgment and discretion. The guide cannot include all possible situations that may be
encountered.

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                             Table of Contents

                                                                        Chapter

PURPOSE AND ORGANIZATION                                                  1

AUDIT OBJECTIVES                                                           2

BACKGROUND                                                               3

PLANNING THE AUDIT                                                         4

MANAGEMENT ASSERTIONS AND INTERNAL CONTROLS                             5

AUDITING THE FINANCIAL STATEMENTS                                          6
      Common areas
      Program Specific:
       Clean Water
       Drinking Water-Set asides

COMPLIANCE AUDITING                                                        7
      Clean Water
      Drinking Water

AUDIT COMPLETION  AND THE AUDITOR'S REPORT                                 8

APPENDICES:
      REFERENCE MATERIAL                                                  A
      SAMPLE ENGAGEMENT LETTER                                           B
      INTERNAL CONTROL REVIEW PROCESS                                    C
      FINANCIAL STATEMENT ASSERTIONS                                      D
      SAMPLE REPRESENTATION LETTER                                       E
      SAMPLE AUDITOR'S REPORT AND FINANCIAL STATEMENTS
            Direct Loan Program, without Administrative Fee Fund                      F-1
            Direct Loan Program, with Administrative Fee Fund                         F-2
            Leveraged Loan Program, State Matching Bonds                           F-3
            Leveraged Loan Program                                            F-4
            Drinking Water Statement of Revenues and Expenses,
             with supplementary information on Set-Aside expenses.                    F-5

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                                     CHAPTER 1
                      PURPOSE AND ORGANIZATION
INTRODUCTION
The State Revolving Funds operated by the states are unique to EPA. The SRFs are EPA's largest
single program, accounting for about 50 percent of all assistance awards.  There are 102 SRF programs
nationally (all 50 states plus Puerto Rico, each operating a Clean Water and Drinking Water SRF). The
size of the individual SRFs vary from small, direct loan programs with only a few loans, to large,
leveraged programs that have several billion dollars in bonds and loans  outstanding. There also are
variations in how each state operates the SRF, and no two states are organized in the same manner.

A large number of states operate the Clean Water and Drinking Water programs in separate
departments, the most common having the Clean Water SRF as a part of the state's environmental
department, and the Drinking Water SRF operated by the health department. Some states have set up
the SRFs in separate entities, ranging from quasi-public corporations to  financing authorities to bond
banks, while other states operate their programs as enterprise funds, special revenue funds, or part of
the general fund. Some entities may have been established solely to operate the SRF (such as a quasi-
public corporation), while in other states the SRF may be a part of other  environmental or financial
assistance operations.

There are also different levels of audit standards or requirements for SRF audits.  As a minimum, SRF
audits should be conducted according to Government Auditing Standards (often called the Yellow Book,
generally accepted government auditing standards, or GAGAS), issued  by the Comptroller General of
the United States. Government Auditing Standards require, among other things, a report on the auditors
consideration of internal controls and compliance with applicable federal requirements over financial
reporting that is not required under American Institute of Certified Public Accountants (AICPA) Generally
Accepted Auditing Standards (GAAS). Since Federal funds are involved, audits conducted solely under
the AICPA Generally Accepted Auditing Standards do not meet the requirements of GAGAS. Several
states audit the SRF under the Single Audit Act, which imposes additional compliance and reporting
requirements. If auditors become aware that the entity being audited is  subject to an audit requirement
not encompassed in the terms of the engagement, the auditor should communicate  to management that
the audit being conducted may not meet the regulatory requirements.1


PURPOSE

The purpose of this guide is to provide guidance in performing audits of  the Clean Water and Drinking
Water SRFs administered by states. This guide is for the use of EPA OIG auditors, state auditors and
Independent Certified Public Accountants when performing SRF financial audits.

The guide is not intended to be a complete manual of procedures, nor is it an audit program.  It is limited
to  matters that warrant special attention and/or that experience has indicated may be useful. This guide
is also based on the assumption that its users are knowledgeable in accounting and auditing. As such, it
focuses on specific areas of auditing, accounting and reporting relevant  to the SRFs. It does not discuss
the application of all accounting pronouncements or auditing standards that may pertain  to SRF audits.
The guide incorporates relevant auditing standards, including General Accounting Office (GAO)
              AICPA Statement on Auditing Standards (SAS) No. 74, Compliance Auditing Considerations in Audits of
              Governmental Entities and Recipients of Governmental Financial Assistance.

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guidance where applicable, and outlines key issues to be considered in SRF programs. However, it is
not a substitute for the existing regulations nor does it eliminate the need to review current GAO
guidance, EPA regulations, state laws, and/or pronouncements issued by the Financial Accounting
Standards Board (known as FASB) and the Governmental Accounting Standards Board (known as
GASB). Auditors are expected to exercise professional judgment in performing SRF financial audits.

The guide was prepared on the assumption that the auditor will have to perform an audit to accomplish
the objectives presented below.  However, the auditor may often determine that work performed by
others  (EPA annual reviews, other audits, and  OMB Circular A-133 audits) may be useful  in meeting the
objectives.  Audit procedures should assure that auditors build on the work of others so that there is not
a duplication of audit effort. Accordingly, while relying on the work of others, the auditor should exercise
judgment whether to perform additional work in each objective. In such cases, consultation with the OIG
National SRF Audit Manager is encouraged.


ORGANIZATION OF THIS  GUIDE

This guide is organized in the same manner that financial statement audits are conducted. Specifically,
the Chapters are:

       2. Audit Objectives: Discusses the objectives of audits of SRF programs, and focus of such
       audits.

       3. Background:  Provides statutory and regulatory authorities for the Clean Water and Drinking
       SRF programs. It also identifies how SRF funds can be used, how the states are  funded, and
       identifies key documents that should be obtained as part of the permanent audit files.

       4. Planning the Audit: Discusses determining the scope of audit, key documents,  obtaining an
       understanding of the SRF, and defining the engagement with the state. Also discusses other
       factors, both internal and external, that may affect the audit and SRF operations.

       5. Management Assertions and Internal Controls: Discusses how the financial statements are
       the representation of management, and how the statements are prepared according to
       assertions made by management, either explicit or implied.  Assessing and testing the internal
       control structure provides reasonable assurance that transactions are properly recorded to
       validate the management assertions.

       6. Auditing the Financial Statements: This chapter discusses determining whether the financial
       statements are presented fairly in all material respects in conformity with GAAP.  It provides a
       general overview of the types of funds  and  accounts, and identifies the auditing and reporting
       concerns of SRFs.

       7. Compliance Auditing: Provides guidance on compliance matters in SRFs that need to be
       addressed to determine whether the state has complied in all material respects with laws,
       regulations, and the provisions of SRF capitalization grants.

       8. Audit Completion and the Auditor's  Reports: Discusses completing the audit which involves
       obtaining a representation letter from the state, presenting the results of the audit, and the
       auditor's reports.

       Appendices: The appendices include a listing of reference materials, sample engagement letters
       and representation letters, and sample financial statements  intended to assist states and
       auditors in making the financial statements as informative as possible.


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                                     CHAPTER 2
                               AUDIT OBJECTIVES
EPA's role in the SRF program is one of oversight of the states. One of the best methods to assist in
EPA's oversight role is to obtain annual financial statements from the states that have been audited.
EPA uses the audited financial statements to determine if the program is operating as intended, and to
gather information necessary to report to Congress.  Audited financial statements also provide EPA with
assurances that the financial statements are fairly presented in accordance with GAAP, the internal
control structure is adequate to safeguard the assets of the SRF, and that the states have complied with
the important compliance provisions of Federal laws and  regulations.

The objectives of audits of the SRFs administered by states are to:

        Express an opinion on the fairness of the financial statements of the SRF programs, and to
       conclude whether such statements are prepared  in accordance with generally accepted
       accounting principles;

        Report on the internal controls related to the financial statements of the SRF.  The report will
       describe the scope of testing of the internal controls, the results of those tests, and if applicable,
       refer to a separate schedule of findings and/or costs questioned; and

        Express an opinion as to whether the state has complied, in all material respects, with laws,
       regulations, and provisions of the SRF capitalization grants and other Federal laws, as
       applicable.

In order to achieve these objectives, the audit needs to be properly planned, conducted, and supervised.
The audit focus is on a state's SRF programs, rather than individual capitalization grants awarded to
the state. The Clean Water SRF program should include all funds relevant to the program,
including administrative or loan fee funds.  The Drinking Water SRF program includes the loan
fund, any set-asides utilized by a state, and administrative  or loan fee funds.

Audits are to be conducted in accordance with GAGAS, and include testing of accounting records and
other procedures the auditor considers necessary to express an opinion that the financial statements of
the State Revolving Fund are fairly presented, in all material respects. Audits include tests of
documentary evidence supporting the transactions recorded in the accounts, direct confirmation of cash
balances, loans receivable and certain other assets and liabilities with selected communities or districts,
and other parties as necessary in the circumstances.  The product of an audit generally includes issuing
the following reports:

        Financial statements with an opinion (or disclaimer of opinion) as to whether the SRF financial
       statements are presented fairly in all material respected in conformity with GAAP. As a
       minimum, financial statements should include a statement of net assets or balance sheet,
       statement of revenues  and expenses and changes in net assets, a statement of cash flows, and
       notes to the financial statements. Other statements may be required, depending upon the
       organization.

        A report on internal controls  related to the SRF financial statements. The report should
       describe the scope of testing of internal control and the results of tests, and where applicable,
       refer to a separate schedule of findings and/or costs questioned.
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        A report on compliance that includes an opinion as to whether the state has complied in all
       material respects with laws, regulations, and the provisions of the SRF capitalization grants.

The objectives and the reports are discussed in more detail in the following chapters. The financial
statements are the representation of SRF management, not the auditor. Auditors should be familiar with
Governmental Auditing Standards issued by the Comptroller General of the United States, as well as
Generally Accepted Auditing Standards issued by the AICPA. Recent events in the accounting
profession will likely have affects on independence of auditors, scope of services, and increased
responsibilities over a variety of areas.
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                                    CHAPTER 3
                                  BACKGROUND

The Clean Water and Drinking Water SRFs are very similar in operation and design. There are some
important procedural and compliance differences between the two programs, but accounting for the loan
portion of both programs is the same.

When the Drinking Water State Revolving Program was established in 1996, it included some provisions
that can affect the Clean Water SRF program. States can transfer up to 33 percent of a Drinking Water
capitalization grant to the Clean Water program, or an equivalent amount to the Drinking Water program
from the Clean Water fund.  States may also combine Clean Water and Drinking Water fund assets to
secure bond issues, which  is known as "cross-collateralization."  Several states operate both programs
in the  same department or entity, and may have the same staff working on both Clean Water and
Drinking Water SRFs.  For those reasons, the two funds may be so intertwined as to make auditing one
program without auditing the other at the same time very inefficient.
STATUTORY AND REGULATORY AUTHORITIES

CLEAN WATER SRF:

Title VI of the Clean Water Act of 1987 (referred to as the Clean Water Act) established the Clean Water
SRF program (CFDA No. 66.458) to replace the wastewater treatment facilities construction grants
program.  The Clean Water SRF program is established in each state by capitalization grants awarded
by EPA.

The expectation of the Clean Water SRF program is for each state to create a permanent revolving fund
to provide funds for making loans to local governments to construct needed wastewater treatment
facilities. The SRF can also be used for other types of projects such as:

        Implementing non-point source pollution control management programs under section 319;
       and

        Developing and implementing estuary conservation and management plans according to
       section 320.

In addition to loans, the Clean Water SRF can provide the following types of other assistance:

        Refinance  existing debt for obligations incurred prior to March 7, 1985 for constructing
       wastewater treatment facilities;

        Guarantee or purchase insurance for local debt obligations, where such insurance would
       improve credit access or lower interest rates;

        Serve as a source of revenue or security for the payments on revenue or general obligation
       bonds if the  bond proceeds are deposited to the Clean Water SRF.  When the Clean Water SRF
       is used to provide security or guarantees of debt obligations, the process is known as
       leveraging.  Leveraging increases the funds available for loans in the early years by using the
       Clean Water SRF to offset interest paid on bonds, and provide a reserve  in  case  of default by
       the state or local community.
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        Provide loan guarantees for similar revolving funds established by municipalities or agencies;

        Earn interest on fund accounts, such as loan repayments or a reserve account used to secure
       proceeds from a tax exempt bond issue; and

        Pay the reasonable costs of administering the Clean Water SRF, provided that the amount
       does not exceed 4 percent of all grant awards.

The Drinking Water Act  provides two additional "uses" for the Clean Water SRFs. States can transfer up
to 33 percent of a Drinking Water capitalization grant to or from the Clean Water program. States may
also "cross-collateralize" the two funds to better secure bond issues.  Several conditions apply, and the
proceeds of such bond issues for each fund must be allocated in the same proportion as the assets
used to secure the bonds.

Uses of the Clean Water SRF are more fully discussed in the Code of Federal Regulations (CFR), Part
40, Subpart K. The regulations identify the exact types of assistance that the Clean Water SRF can
provide, and also discusses additional requirements, limitations, and procedures for establishing and
operating the Clean Water SRF.

The Clean Water SRF program provides a high degree of flexibility for states in operating their revolving
funds in accordance with each state's unique needs and circumstances. EPA recognizes that each state
may have different needs and has administered the SRFs to meet those particular needs.
DRINKING WATER SRF:

Title I of the Safe Drinking Water Amendments of 1996 (the Drinking Water Act) established the Drinking
Water SRF program (CFDA No. 66.468) to provide assistance to states and communities to help the
communities meet Federal drinking water requirements.

Like the Clean Water SRF, the Drinking Water SRF is established by capitalization grants awarded by
EPA.  Each state's program is expected to be designed and operated to further the public health
protection objectives of the Act, promote the efficient  use of all funds allotted to the state, and to ensure
the revolving loan fund is available in perpetuity for providing financial assistance to public water
systems.

When the term Drinking Water SRF  is used in this guide, it refers to the entire Drinking Water SRF
program, including set-asides. The term "loan fund" is used when referring to the revolving loan fund.
The term "set-aside fund(s)" is used  to describe the various set-aside activities.

Loan Fund

The primary purpose of the Drinking Water SRF program  is to create a permanent loan fund in each
state for the states to make low-interest loans to public water systems to address current or prevent
future violations of Federal drinking water standards.  It can be used for public water system projects in
the following categories:

        Water treatment
        Water transmission and distribution
        Source water protection
        Water storage
        Consolidation of water systems
        Creation of new systems (where such project will address existing public health problems
       caused  by unsafe drinking water provided by existing sources.)

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The loan fund can also be used to provide the following types of assistance:

        Refinance or purchase local debt obligations for projects initiated after July 1, 1993;
        Purchase insurance for or guarantee local debt obligations;
        Use revenues or otherwise provide security for debt obligations of the loan fund, provided the
       net proceeds of the sale of the debt obligations  are deposited into the loan fund and used to
       provide assistance eligible under the Act.

Unlike the Clean Water SRF, the Drinking Water SRF can also be used to provide assistance to
disadvantaged communities in the form of loan subsidies. Disadvantaged communities can have loan
principal forgiven,  may have negative interest rate loans, and can extend the loan repayment period
to 30 years after project completion (provided the loan does not exceed the expected useful life of
the project. Also, the Drinking Water SRF can provide financing for privately owned water systems
where the Clean Water SRF can only finance public systems.

Set-Aside Funds

The Drinking Water program also includes several "sub-programs," called set-asides, that states can
elect.  A State may use a certain portion of its capitalization grants for the following activities:

         up to 4 percent of its allotment to administer the Drinking Water SRF and provide technical
          assistance to public water systems;
         up to 2 percent of its allotment to provide technical assistance to small public water systems;
         up to 10 percent of its allotment for state program management activities, including
          administration of the State Public Water System Supervision Program, administration of the
          source water protection program, development and implementation of the capacity
          development and operator certification programs;
         up to 15 percent of its capitalization grants to assist in the development and implementation
          of local drinking water protection initiatives and other State programs.

A significant difference between the  Clean Water and Drinking Water SRFs  is in the area of fund
administration. The Clean Water SRF allows states to use up to 4 percent of the capitalization grant for
administrative expenses in the Clean Water SRF.  In the Drinking Water SRF, the 4 percent
administrative set-aside and other set-asides cannot be part of the Drinking Water SRF fund. They
must be deposited to separate funds, and must have separate accounting. For this reason, financial
statements of Drinking Water SRFs must report all set-aside funds separate from the Drinking Water
loan fund. Examples of how this separate reporting can be accomplished in the financial statements is
included in the appendices.

Uses of the Drinking Water SRF are more fully discussed in the CFR, Part 40, Subpart L. The
regulations identify the exact types of assistance that the Drinking Water SRF can  provide, and
additional  requirements, limitations, and procedures for establishing and operating the Drinking Water
SRF.

EPA implements the Drinking Water SRF in a manner that preserves a high degree of flexibility for
states in operating their revolving funds  and set-aside funds in accordance with each state's unique
needs and circumstances.
FUNDING THE STATE REVOLVING FUNDS

EPA's capitalization grants provide the initial SRF financing. The Clean Water and Drinking Water
grants require that the states provide a 20 percent match. The state match can be made by a number of
methods, such as direct appropriation, general obligation bonds, revenue bonds, or other methods.

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When a state receives a capitalization grant, it agrees to a "payment schedule" with EPA. However, the
"payment schedule" does not represent actual payments. A payment in SRF terms are authorized
increases to the amount a state can draw from EPA through the Automated Clearing House (ACH). The
payment schedule identifies the dates that the funds will be available to the state. The state generally
has one year after the payment to obligate the funds, which is known as making  "binding commitments."
The binding commitments must equal at least 120 percent of the payments received one year earlier,
which accounts for both the federal and state shares of the SRF.  A significant difference between the
Clean Water and Drinking Water SRFs is in the area of required binding commitments.  Amounts that
states elect for the set-asides do not affect the state match required, or the required binding
commitments. States must provide the 20 percent state match on the total  Drinking Water
capitalization grant, exclusive of all set-asides.

Draws are typically made when a state is presented with reimbursement requests from the loan
recipients. Both Clean Water and Drinking Water programs require that draws from EPA be made in
proportion to the total funds deposited to the SRF, also called proportionality. In a Clean Water direct
loan program, the state will draw 83.332 percent of the requested amount from EPA, transfer the state
share to the Clean Water SRF (16.67 percent), and then issue the reimbursement to the communities
involved. How funds  are drawn, and the amounts drawn, will vary for leveraged programs, depending
on the exact method used. The EPA share  will be 83.33 percent regardless  of whether the funds are
disbursed to a community or deposited to a  reserve account as security for bonds.

However, the EPA share for the Drinking Water program will only be 83.33 percent if the state does not
elect any set-asides, including the administrative set-aside. States that only elect  the administrative
set-aside will have a state share of 17.24 percent. Proportionality can vary by year for the Drinking
Water SRF, depending upon the set-asides elected by the state. The following table shows how the
state portion of cash draws changes depending upon the set-asides3:
Year
1
2
3
Cap
Grant
100
100
100
State
Match
20
20
20
Set-
aside
15
20
31
Federal
85
80
69
State
20
20
20
Total
105
100
89
Federal
Portion
81%
80%
78%
State
Portion
19%
20%
22%
States can also choose between specific grant proportionality, as shown above, or may use a rolling
average. Funding the Drinking Water program and cash draws are discussed in detail in EPA's "Guide
to Using EPA's Automated Clearing House for the Drinking Water State Revolving Fund Program."
               For Clean Water SRF, the Federal and state shares are calculated as follows:

                                                   Amount
               Federal grant
               State match

               Total Clean Water SRF funds
$ 100
	20
Percentage
    83.33
    16.67

   100.00
               For the Drinking Water program, the formula to calculate Federal share is:

                                                       Capitalization grant - set-asides
                                                   Capitalization grant - set-asides + state match
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KEY DOCUMENTS

In addition to the capitalization grant terms and conditions, there are several other key documents
relating to a state's SRF program:

         Operating Agreement;

         Intended Use Plan;

         Annual/Biennial Report;

         Annual Review, and;

         State's Single Audit Report.

Operating Agreement. At the option of the State, the organizational and administrative framework and
those procedures of the SRF program that are not expected to change annually may be described in an
Operating Agreement.  The  Operating Agreement is incorporated by reference in the capitalization grant
agreement. (40 CFR 35.3130(b), 40 CFR 35.3545(c)).

Intended Use Plan. The State must prepare a plan identifying the intended uses of the funds in the
SRF and  describing how those uses support the goals of the SRF.  The Intended Use Plan must be
prepared  annually and  must be subjected to public comment and review before being submitted to EPA.
(40 CFR 35.3150, 40 CFR 35.3555(a)). Workplans are required for set-aside activities of the Drinking
Water SRF.

Annual Report. The State  must provide an Annual Report to EPA (Biennial report for Drinking Water).
The Annual Report includes information essential to EPA evaluating the SRF program, and includes how
the state is meeting the goals and objectives of the program. (40 CFR 35.3165(a), 40 CFR 35.3570(a)).
Financial  statements are a required part of the Annual Report.

Annual Review.  The  Annual Review is  EPA's assessment of the success of the State's performance
of goals and activities identified in the Intended Use Plan and Annual Report, and to determine
compliance with the terms of the capitalization grant agreement. (40 CFR 35.3165(c), 40 CFR 35.70(c)).

State's Single Audit Report. OMB Circular A-133 requires a state to conduct an annual audit, known
as the Single Audit. The scope of this audit  includes work that can be of value to the auditor conducting
the SRF financial statement audit, especially in years in which the SRF is treated as a "major" program.

REFERENCE MATERIAL

In planning and conducting financial audits of state SRFs, and reporting the results, access to and
review of certain reference material is important.  Reference material is identified in Appendix A.
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                                     CHAPTER 4

                             PLANNING THE AUDIT

Conducting an audit of the financial statements of the SRF requires that the audit be properly planned
and supervised. GAGAS for financial statement audits have incorporated the fieldwork standards
established by the AICPA. The guidance in SAS No. 22, Planning and Supervision, provides procedures
applicable to planning and supervising an audit.

Planning is an essential step in order to determine an effective and efficient way to obtain the evidential
matter necessary to report on the financial statements. The nature, extent, and timing of planning varies
with the size and complexity of the SRF, the auditor's experience with the particular SRF, and the
auditor's knowledge of the SRFs operations. Audit risk and materiality are also important considerations
during the planning stage. Planning the audit is the key to a quality audit, and requires the  involvement
of senior members of the audit team. Although concentrated in the planning phase, planning is
performed throughout the audit.  For example, results of the internal control phase have a direct impact
on planning the substantive audit procedures.

In planning the audit,  the auditor needs to: (1) determine the audit scope; (2) obtain key documents and
information; (3) obtain an understanding of the SRF; and (4) define the engagement with the state and
arrange an entrance conference.

AUDIT SCOPE

An audit of a state's SRF financial statements should include the SRF  financial statements  for the most
recent period. The EPA regional SRF Coordinator should be contacted prior to initiating the audit
engagement to assist in determining  the period of audit. Typically, the SRF financial statements  should
be available from the state's Annual (or Biennial) Report on the SRF program. The auditor is reminded
that the SRF financial statements are those of the state's SRF management and, as such, the state is
required to provide certain explicit and implied assertions with their financial statements (see Chapter 5 -
Management Assertions and Internal Controls).

KEY DOCUMENTS AND INFORMATION

Preliminary planning for the audit engagement includes obtaining  the key documents discussed in
Chapter 3. In addition, the Region's SRF Coordinator should be contacted to obtain EPA's perspective
on strengths or weaknesses of the state's SRF program and names of state contacts.

Auditors should carefully review and  assess the key documents for planning the performance of the
audit. Auditors are encouraged to build upon the work performed  by others, provided that the auditor is
willing to accept full responsibility for the work.  In such cases, the nature, timing and extent of tests
performed may be able to be reduced because of work performed by EPA during its annual review, or by
other auditors performing SRF-related audits or audits required by OMB Circular A-133.

OBTAINING AN UNDERSTANDING OF THE SRF

The auditor should obtain a sufficient understanding of the SRF to plan and perform the audit in
accordance with GAGAS and specific EPA requirements.  This consists of gathering information to
obtain an overall understanding of the SRF, including the origin and history of the state's SRF, and the
SRF's size, organizational structure,  mission, operational strategies, inherent risks, control environment,
and internal controls.
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The auditor's understanding of the entity and its operations does not need to be comprehensive, but
should include:

        SRF management and organization;

        External factors affecting operations;

        Internal factors affecting operations; and

        Accounting policies and procedures.

For Drinking Water programs, auditor's should also determine to what extent the state has elected to
participate in the set-aside programs available.

SRF Management and Organization. As a starting point in gaining an understanding of the SRF, the
state's legislation that established the SRF and implementing regulations should be reviewed. The
legislation will normally include the type of fund established  for the SRF, indicate how the SRF will be
organized and managed, and establish levels of authority. Whether the SRF is established within an
existing state department or as an independent entity will have a significant affect on the accounting
policies and internal controls of the SRF. Legislation and regulations may also include information about
cash management, investments, debt issuance, and interaction with other state departments or funds.

The auditor should identify key members of management and obtain an understanding of the
organizational structure.  The main objective is to understand how the entity is managed and how the
organization is structured.  The style of management will have a significant impact on the financial
statements,  internal control structure and effectiveness, and the conduct of the audit.

One of the first steps in understanding the SRF and the organization is to determine the type of fund that
the state  has established for its SRF.  The type of fund used will dictate many of the accounting
principles and policies to be followed, as well as the presentation of the financial statements. Since one
of the primary objectives of the SRF is to provide a permanent financing institution in each state, much
like a bank or loan company, the accounting and the financial statements should be similar to those of a
financial institution.  As such, the preferred method of accounting for the SRF is as a proprietary
(enterprise) fund. However, many states account for the SRF as a special revenue fund or a trust fund.
Some states account for the SRF as part of the general fund.  While EPA has never issued any
guidance on how to account for the SRF, GASB 34 does. While GASB 34 provides requirements for a
governmental entity's basic financial statements, it also specifies the type of fund to be used for certain
activities. These requirements will require a number of states to change the type used to account for the
SRF. Chapter 6 - Auditing the Financial Statements, discusses the new accounting changes in detail.

External Factors. Regardless of how the state accounts for the SRF, there are a number of factors that
affect the operations, both  external and  internal.  External factors might include (1) source of funds for
the state  matching requirement,  (2) whether the state has "leveraged"4 its program, (3) current political
climate, (4) relevant legislation, and (5) accounting pronouncements.

Internal Factors. Internal factors might include the: (1) type of fund used to account for the SRF, (2)
size of the fund, (3) composition of the loan portfolio, (4) structure of the program and complexity of
operations, (5) the number of other governmental agencies  involved, (6) qualifications and competence
               Leveraging is when a state issues debt to increase the amount available for loans. The SRF can be used to
               guarantee the debt, and interest earnings can offset the interest on the debt. There are a number of variations
               on two basic methods used by the states.  Specific auditing and financial reporting issues involved will depend
               on the leveraging method.

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of key personnel, and (7) turnover of key personnel.  Participation in the set-asides of the Drinking Water
program is also a key internal factor. Set-asides often include other state agencies and subcontractors,
and understanding how the state operates the set-aside programs, and the extent of participation, will
have material effects on the organization and audit.

Accounting Policies and Procedures. In identifying accounting policies and procedures, the auditor
should consider applicable accounting principles and pronouncements, including whether the entity is
likely to be in compliance with those principles.  Auditors should also be aware of recent accounting
pronouncements, and how those pronouncements will affect the entity. GASB 33 and 34 require drastic
changes in accounting for various items, and may have  minimal effect on other items. Auditors should
consider whether management has changed any accounting principles, and whether management
appears to follow aggressive or conservative accounting policies. Understanding the state's SRF
operations early in the planning process enables the auditor to identify, respond to, and resolve
accounting and auditing problems early  in the audit.

ENGAGEMENT LETTER AND ENTRANCE CONFERENCE

An engagement letter should be sent to  the state (with a copy to the Regional SRF Coordinator).  At a
minimum, the letter should include: (1) announcement of the audit, including the audit scope and
objectives; (2) proposed entrance conference date; (3) information needed prior to or at the entrance
conference; (4) schedules to be  prepared by the state; and (5)  name of the audit team leader.  A  sample
engagement letter is included in Appendix B.
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                                   CHAPTER 5
                       MANAGEMENT ASSERTIONS
                        AND INTERNAL CONTROLS
The majority of an independent auditor's work in forming an opinion on the financial statements consists
of obtaining and evaluating evidential matter concerning the assertions in the financial statements. The
internal control system consists of policies and procedures established by management to ensure that its
assertions are valid.

MANAGEMENT ASSERTIONS

The financial statements of the SRF are the representations of management. The financial statements
are prepared according to various management assertions, which are either explicit or implied.

The management assertions in the financial statements include:

         Existence or occurrence: The assets and liabilities of the organization exist at a given date,
       and recorded transactions occurred during the period.

         Completeness: The financial statements include all transactions and accounts that should be
       included.

         Rights and obligations: Assets are valid rights of the organization and liabilities are proper
       obligations.

         Valuation or allocation: The accounts are recorded and presented at appropriate amounts.

         Presentation and disclosure: All components of the financial statements are properly
       classified, described and disclosed.

The audit serves as an independent review of the assertions, and verifies that management's assertions
are accurate. After the internal controls have been reviewed and documented, the effectiveness of
management's assertions is assessed, as discussed in the section titled "Assessing Control Risk."

Appendix D lists each management assertion, along with potential misstatements, and includes specific
control objectives to address each assertion.

INTERNAL CONTROLS

Internal controls can be reviewed once an understanding of the organization, management and
accounting policies is obtained. The AlCPA's second standard of fieldwork states "a sufficient
understanding of internal control is to be obtained to plan the audit and determine the nature, timing, and
extent of tests to be performed." SAS No. 55, Consideration of Internal Control in a Financial Statement
Audit, as amended by SAS No. 78, Consideration of Internal Control in a Financial Statement Audit: An
Amendment to SAS No. 55, provides guidance on the auditor's consideration of an entity's internal
controls in financial statement audits performed in accordance with generally accepted auditing
standards.
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Internal control is defined as:

       A process-effected by the entity's board of directors, management, and other personnel-
       designed to provide reasonable assurance regarding the achievement of objectives in the
       following categories: (a) reliability of financial reporting, (b) effectiveness and efficiency of
       operations, and (c) compliance with applicable laws and regulations.

The objectives are what the entity strives to achieve. The components of the internal control system
represent what is needed to meet those objectives.  The internal control system consists of five
interrelated components: the control environment, risk assessment, control activities, information and
communication, and monitoring. The controls that are relevant to  an audit pertain to the state's objective
of preparing financial statements that are fairly presented in conformity with generally accepted
accounting principles or other comprehensive basis of accounting.

INTERNAL CONTROL STRUCTURE

The objectives of the internal control structure are to provide reasonable  assurance that assets are
safeguarded against loss, and that transactions are properly recorded to  validate the management
assertions. The elements of the internal control system, and their relationship to the audit of the financial
statements, are:

Control Environment. The control environment sets the  overall tone of the organization.  It represents
the collective effect of various factors on establishing, enhancing or mitigating the effectiveness of
specific policies and procedures.  The control environment  reflects the overall attitude and  actions of the
SRF program within the state,  including legislative, management, staff and others concerning the
importance of the controls. The control environment includes such factors as:

        Integrity and ethical values;

        Commitment to competence;

        Legislature or Governing board;

        Management's philosophy and operating style;

        Organizational structure;

        Assignment  of authority and responsibility, and;

        Human resources policies and practices.

The importance of these factors will vary according to the size, complexity, and sophistication of the SRF
program. The auditor should obtain enough knowledge of the control environment to understand the
attitude of management and its actions regarding the control environment. Auditors should also be
aware that the substance of management's policies and actions are more important than the form
because appropriate policies and  procedures may be established, but not followed.

To judge the effectiveness  of the control environment, the auditor  needs  to consider these  factors and
how the factors affect the audit. However, not all factors will have the same weight in each case, and
the auditor does not need to understand each factor to the same degree  of detail. The extent of
understanding for each factor is a matter of professional judgment.
       5 AICPA Professional Standards, AU 319.06
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Risk Assessments.  Risk assessment is the identification of risks that may prevent the SRF program
from meeting its organizational objectives, and forms the basis for how the risks should be managed.
The risk assessment for financial reporting purposes involves identification, analyses, and management
of risks relevant to preparing financial statements in conformity with generally accepted accounting
principles. The primary concern is to consider how the possibility that certain transactions not recorded
could be prevented or detected.

Risks can  be internal, external or both.  Risks may affect the organization's ability to record and process
financial data consistent with the management assertions.  Risks can arise or change due to:

        Changes in operating environment;

        New personnel;

        New or revised  information systems;

        Rapid growth or technology changes;

        Reorganizations, or;

        Accounting pronouncements.

Sufficient knowledge of the organization's risk assessment process is necessary to understand how
management considers risks relevant to financial reporting objectives, and determine what actions
should be taken to address those risks.  Auditors need to understand that the organization's risk
assessment will likely differ from the auditor's.  The auditor's risk assessment is mainly concerned with
likelihood that material misstatements in the financial statements could occur. The organization's risk
assessments will include factors outside the financial statements.

Control Activities. Control activities are the policies and procedures that assist management in
carrying out  its directives. Control  activities are generally the specific activities  or procedures that
management has established to address the risks that the management assertions contained in the
financial statements are met. Control activities that would be applicable to the SRF would include:

        Performance reviews;

        Information processing;

        Physical controls, and;

        Segregation of duties.

A thorough understanding of the control activities is vital to planning the audit. As  information is
obtained about other components of the internal control system,  information about the control activities
is also obtained.  For example, when reviewing the cash  receipts and disbursement functions, the
auditor would also determine if bank accounts are reconciled, and who reconciles them. The presence
or absence of control activities learned  from reviewing  other activities should have an effect on the
auditor's decision to devote  additional time to certain areas of the audit.

The goal is to determine whether the internal controls are adequate to identify potential misstatements in
the financial  statements, and to design  substantive tests to provide reasonable  assurance that
misstatements do not occur.
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Information and Communication. The information and communication system relevant to financial
reporting includes the accounting system.  The system consists of methods and procedures to record,
process, summarize and report transactions, and to maintain accountability over assets and liabilities.
The accounting system has a significant affect on the potential for misstatement, and the design of
substantive audit tests and procedures.

The information system includes methods and records that:

         Identify and record all valid transactions;

         Describe the transactions in enough detail to permit proper classification of transactions;


         Measure the proper value of transactions;

         Determine that the transactions are recorded in the proper time period;

         Present the transactions and related disclosures in the financial statements, and;

         Allow and promote communication among employees.

The type of fund that the state has  established for the SRF will dictate many of the accounting principles
and policies that are followed, as well as financial presentation of the  financial statements. One of the
objectives of the SRF was to provide a permanent financing institution in each state, much like a bank or
loan company.  Therefore, the accounting and the financial statements should be similar to those of a
financial institution. Accounting for the SRF as an enterprise fund allows all transactions to be recorded
in a single fund, including leveraging operations, and facilitates preparing the financial presentation
necessary to assess the financial position and results of operations. However, some states account for
the SRF in other types of funds, most commonly in Special Revenue funds, although at least one state
uses a trust fund,  and another accounts for the SRF as part of the general fund.  Regardless of the fund
type used, the auditor should thoroughly understand the accounting records, supporting information, and
specific accounts included in the financial statements for the fund type used  by the state.

If the SRF is not accounted for as an Enterprise fund, there will likely  be several other types of funds or
account groups involved, such as the general fund, debt service funds, capital outlay funds, and the
long-term debt and fixed assets groups of accounts.  Auditors should  have a complete understanding of
how the different funds are interrelated for the financial statements to fairly present the financial  position
of the SRF.

Monitoring. The  effectiveness of management's specific policies for monitoring internal controls,
including internal and external audits, should be evaluated. Internal and external audits are important
aspects of monitoring internal controls, but monitoring can also include the normal recurring operations
of the organization. For example, errors can be discovered during the normal operations that could
identify a control activity or procedure that is not effective.


OBTAINING AN UNDERSTANDING OF INTERNAL CONTROLS

The primary methods of obtaining an understanding of the internal  controls needed to make decisions
about the extent of reliance that can be placed on the internal control  system include:

         Prior experience with the organization;

         Inquiries of appropriate management, supervisory and staff personnel;

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        Inspection and testing of documents and records, and:

        Observation of the organization's activities and operations.

The extent of the procedures will vary with the size and complexity of the SRF, previous experience, the
particular controls involved, and professional judgment.

DOCUMENTING THE UNDERSTANDING

The understanding of Internal Controls should be properly documented in the workpapers. The exact
form and extent of the documentation will vary according to the size  and complexity of the organization.

The documentation required for a small, direct loan program with a small number of loans would not be
as extensive as a leveraged program with hundreds of loans, bonds payable, bond reserves, and other
complexities. A small program could be adequately documented by a  memorandum in the files that
describes the system, whereas a larger program may require several files, flowcharts, questionnaires,
and other audit aids.  Regardless of the form and quantity, the documentation should include information
on:

        The classes of transactions that are important to the SRF;

        How the transactions are initiated;

        The source documents;

        The accounting processing, including computer files;

        The chart of accounts;

        Samples of documents, journals, ledgers and reports generated by the financial reporting
       system;

        Descriptions of control activities;

        How the state provides the matching share of the SRF; and

        The financial reporting process used to prepare the financial statements.

If the SRF is a leveraged program, the amount of documentation would generally increase, and should
include details on the leveraging, including:

        A description of the leveraging  method used;

        The type of bonds issued, such as general obligation, revenue, or other bonds;

        How the SRF  issues and accounts for bond proceeds, and the related liabilities, reserves,
       interest earned and paid, bond maturities, and other related  matters;

        Debt service requirements, and;

        Financial disclosure requirements, such as interest rates, covenants, contingencies, and
       restrictions that may be placed on other assets.
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ASSESSING CONTROL RISK

After the internal control structure has been reviewed and documented, auditors need to assess the risk
that there could be a material misstatement in the financial statements. The review procedures should
be sufficient to obtain an understanding of internal control that will support a low assessed level of
control risk.  Assessing control risk is a process of evaluating the design, effectiveness, and structure of
the internal controls in preventing or detecting a material misstatement in the financial statements.

Control risk should be assessed for relevant assertions that are related to each significant account
balance or class, and may be assessed for specific objectives that relate to the assertions.

However, not all assertions need the same level of evaluation because some assertions may not be
significant for certain account balances or classes of transactions. Similarly, not all assertions need to
be assessed for every account because some assertions are affected by the same controls. For
example, the assessment of control risk of the existence, rights and obligations, and gross valuation of
loans receivable could be made concurrently because the assertions are all affected by the same
controls.

Low Control Risk.  Assessing control risk at less than the maximum is related to the effectiveness of
internal controls in preventing a material misstatement of the financial statements. The process involves
identifying specific controls for specific assertions that are likely to prevent a material misstatement, and
testing the effectiveness of the specific controls.

The controls can be directly or indirectly related to a particular assertion. The  more direct the control, the
more  effective the control is likely to be in reducing control risk.

Control tests are intended to assess the effectiveness of the control, and whether the control is suitable
to prevent or detect misstatements in financial statement assertions.  Tests normally include procedures
such as making inquiries of appropriate personnel, inspecting documents and reports,  and observing
specific controls and procedures. A combination of procedures may be necessary to obtain a level of
understanding sufficient to make an assessment of the control risk.

When the control risk is considered to be less than maximum, the files should contain enough evidential
matter to support the assessment. The evidential matter that is sufficient to support the assessed level
of risk is a matter of judgment, and can vary from year to year.  For complex organizations and
programs, flowcharts, questionnaires, and decision tables may be helpful in applying the tests and
analyzing the results, and would also document the assessed level of risk.  Decisions about the nature,
extent and timing of tests of controls also affect the degree of assurance the evidential matter provides.

Maximum Control Risk.  Assessing control risk at the maximum means that there is a risk of a material
misstatement in an account that would not be detected or prevented by the internal controls. Control risk
should be assessed at the maximum level for some assertions if the review of the  internal control
structure reveals that:

         Controls are unlikely to pertain to an  assertion, or;

         Controls are not effective.

The level of assurance needed from substantive tests remains the same whether control risk is
assessed at the maximum because of audit efficiency reasons or ineffective controls. The fact that the
controls are ineffective may also raise questions about the auditability of the account, or the entire
organization. In such cases, changing the nature, timing and extent of substantive procedures may be
warranted.
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The type of fund used to account for the SRF will also influence control risk assessments. For example,
a leveraged program accounted for as a special revenue fund would generally have a higher risk of
misstatement than a similar program accounted for as an enterprise fund because not all transactions
are accounted for in the special revenue fund. The interaction between other funds and combining the
other funds into the financial statements would generally increase the chance of a material misstatement
in the financial statements.

Nature. Extent and Timing of Tests. The type of tests depends on the particular assertion being
tested, and the evidential matter that is available to evaluate the controls.  Some controls are well
documented,  and for others, such as segregation of duties, documentation may not exist.  Assessing
whether there is adequate segregation of duties would be primarily  by observations of the operations
and inquiries  of appropriate personnel.  Evidence obtained directly,  such as by observing the operations
of a department, provides more assurance than evidence obtained  by other methods, such as inquiries.
However, auditors should  be aware that the control observed  may not be followed if the auditor were not
present.

More extensive tests normally provide increased evidence about the consistency of the application of a
control, and may support a lower assessed control risk.  For example, observing a daily procedure only
once may not be representative of how the procedure is followed on other days, or by other people.
Additional observations or other procedures may be advisable or necessary to obtain a thorough
understanding of the control, and the consistency of the application.

The timing of audit tests also influences the degree of risk associated with the assertion. Tests that
pertain to only one point in time would be appropriate for some tests, but not others. The results of tests
should be evaluated with the timing of the test in mind.  When tests may not be representative of the
entire audit period, other tests or procedures should be conducted to provide evidential matter about the
entire period.  Evidence obtained from prior audits  and  interim periods may provide the additional
information needed to assess the control risk.  However, if the controls or procedures have changed
since the prior audit work, reliance on prior work would  not be appropriate. The length of time that has
elapsed between the prior work and the current audit would also influence the reliance placed on the
prior work. When using prior or interim work, the auditor should consider:

        Evidence about changes in the effectiveness of the  design of the controls:
          - Are the system and controls in place the same as in the prior or interim period?
          - Is the organization the same, or has it  changed?

        Evidence about changes in operating effectiveness:

          Adverse Conditions:
          - Has there been a  change in management attitudes about internal controls?
          - Is there any change in the nature or quantity of the transactions processed?
          - Is employee turnover excessive?
          - Have there been any staff reductions that increased the workload for remaining employees?

          Positive Conditions:
          - Are procedures manuals well documented and followed?
          - Is the department closely supervised, with good communication lines and lines of
          responsibility?
          - Have there been periodic reviews by internal auditors?
          - Are computer controls adequate?

If the adverse conditions are not present, the prior  audit evidence would be more relevant, and could be
given greater reliance. If there have been a number of changed conditions, relying on evidence gained
from prior audit work would not be appropriate.

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When interim audit work is performed for the current year, the auditor needs to document that the
procedures in place during the interim period reviewed are still valid, and being followed.  If the
procedures, or any other aspects of the organization has changed that affect the controls  being tested,
then the interim work should not be relied upon for assessing the control risk.
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                                     CHAPTER 6

               AUDITING THE FINANCIAL STATEMENTS

This chapter focuses on the first audit objective:  To determine whether the SRF financial statements are
presented fairly in all material respects in conformity with GAAP.  It provides a general overview of the
types of funds and accounts that may support the SRF financial statements, and identifies the auditing
and reporting concerns that face SRF auditors.  States use different methods of accounting for SRFs
and its operations.  As such, this guide cannot cover every situation in all states, and professional
judgment must be used in conducting audits.

FINANCIAL REPORTING ENTITY AND SRF FINANCIAL STATEMENTS

With the audit objective focusing on the SRF financial statements, only the accounts of the SRF should
be audited,  with the opinion on the SRF financial statements. However, most SRF programs contain
other accounts or funds that are an integral part of the SRF program, and are to be included as part of
the basic financial statements.  An example of such a fund would be an administrative or loan fee fund,
as well as set-aside funds in the Drinking Water program. Many states charge a loan fee to borrowers to
pay for future costs of administering the program. While the fee may be a one-time charge when the
loan is originated, or an annual fee based on a percentage of the outstanding loan balance, the fund
where the fee is deposited should be included with  the basic financial statements of the SRF.  Such fees
are generally considered to be program income6, and EPA can direct the uses of such program income.
Also, agency funds are sometimes used to account for the revenue bond activity of an SRF program,
and in such cases, should be included as  part of the financial statements as well.

In some states, the organization of the SRF may make it more efficient to audit the financial statements
of the entire entity, with supplemental statements supporting the SRF portion.  Many states operate the
SRF program as part of a state-wide  bond bank, or infrastructure authority. These organizations
generally have audits because they have separate  boards of directors, or are a quasi-public corporation.
In such cases, auditing the SRF itself is a  part of the overall audit of the organization. However, it is
essential  that the SRF operations be  presented in the financial statements be included in the auditor's
report, and  may be included as supplemental information.


ACCOUNTING PRONOUNCEMENTS

There have been several statements  issued by GASB since 1998 that have major impacts on the
financial statements of government entities. Whether the SRF program is a part of the state's general
government operations, or a special-purpose district,  these statements dictate the format of the financial
statements, and in many situations, the organization of the SRF program.  These statements, and a brief
discussion of how they affect the SRFs, is discussed  in the following sections:

       ! No. 33-Accounting and Financial Reporting for Nonexchange Transactions, issued December
       1998,

       ! No. 34-Basic Financial Statements-and Management's Discussion and Analysis-for State and
       Local Governments, issued June, 1999,
              40 CFR 31.25 defines program income as "gross income received by the grantee or subgrantee directly
              generated by a grant supported activity, or earned only as a result of the grant agreement during the grant
              agreement."  In the case of loan fees, there would not be any fee generated if the state did not have the loan
              program.

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        !  No. 37-Basic Financial Statements-and Management's Discussion and Analysis-for State and
       Local Governments: Omnibus, issued November 2001, and

        !  No. 38-Certain Financial Statement Note Disclosures, issued November 2001.

GASB 33: GASB 33 establishes the accounting and financial reporting standards for nonexchange
transactions involving financial or capital resources, which includes most grants. A nonexchange
transaction is when a government gives value to another party without receiving equal value in
exchange. GASB 33 addresses the timing of when a nonexchange transaction occurs, and when the
transaction should be recorded. GASB 33 identifies four classes of nonexchange transactions:

       (1) derived tax revenues, such as sales taxes and income taxes,
       (2) imposed nonexchange revenues, such as property taxes,
       (3) government mandated nonexchange transactions, such as mandated federal or state
       programs, and
       (4) voluntary nonexchange transactions, like certain grants and private donations.

Although none of the examples cited in GASB 33 are SRF specific, the government mandated
transactions are most similar to the SRF. The SRF meets this requirement because the Federal
government  provides resources (capitalization grants) to the states, and requires that states use the
resources for specified purposes. The principal characteristics of these transactions are (1) that the
provider mandates that a recipient government perform a particular program, and (2) fulfillment of
certain eligibility requirements is essential for a transaction to occur. In the SRF, EPA provides
resources to the state on a reimbursement basis, and the recipient has incurred the costs. Until those
eligibility requirements are met, there is no liability on behalf of EPA, and the state does not have a
receivable. When all eligibility requirements  are met, states should record the amount due as a
receivable from EPA.

In practice, this means that the EPA capitalization grant should not be accrued when awarded.  Only as
reimbursement requests are received from the borrowers should the amount due from EPA be recorded.
Similarly, loan commitments are not liabilities of the SRF until the communities make a reimbursement
request. Additionally, footnote 18 requires recognition of capital contributions to proprietary funds and
other entities that use proprietary fund accounting as revenues. These are non-operating  revenues that
should be shown after income from operating activities.

GASB 34: GASB 34 has substantial impacts on the fund type and the basis of accounting to be used for
SRF operations.  It also changes the format of the financial statements, and introduces Management's
discussion and analysis (MD&A), a component of "required supplementary information" (RSI).  MD&A
should introduce the financial statements and provide an analytical overview of the financial activities.
RSI is budgetary comparison schedules and  other data as required by previous GASB pronouncements.
While MD&A is part of RSI, it is presented before the financial statements.

Prior to GASB 34, there was little guidance on what type of funds to be used for governmental
operations, and what was required in the basic financial statements. GASB 34 establishes financial
reporting standards for state and local governments, including cities, special purpose districts, and  public
utilities.  It requires the basic financial statements to include MD&A, government-wide financial
statements, fund financial statements, notes  to the financial statements, and required supplementary
information.  The term  special-purpose districts would include separate legal entities, such as financing
authorities, water boards, and other environmental agencies that contain SRF programs.  If the entity
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includes both governmental and business-type activities that many states have established7 the financial
statements should be reported in the same manner as general purpose governments.

Special-purpose governments engaged only in business-type activities should present the financial
statements for enterprise funds. The financial statements consist of MD&A, a statement of net assets
(balance sheet), and a statement of revenues and expenses and changes in fund net assets, notes to
the financial statements, and RSI, if applicable. The statements should report all assets, liabilities,
revenues, expenses and gains and losses of the entity, and distinguish operations (such as Clean  Water
and Drinking Water) by presenting in separate rows and columns.  Financial statements are to use the
economic resources measurement focus and the accrual basis of accounting.8

GASB 34 also made significant changes to the financial statements as well. Assets and liabilities should
be classified between current and long-term,  and fund equity is now more properly known as "net
assets." Contributed capital is not to be shown as a separate component on the statement of net assets.
Net assets should be shown in three components: invested in capital assets, restricted, and unrestricted.
The most common designations for the SRF will be restricted, which are amounts to be used for debt
service and interest payments and cannot be used for other purposes, and unrestricted.

The statement of revenues and expenses now includes changes in net assets,  not just fund balance.
Revenues should be reported by major source, and should identify revenues used as security for
revenue bonds .  It also distinguishes between operating and nonoperating revenues and expenses,  and
should report separate totals for operating revenues, operating expenses, and operating income.
Nonoperating income should be shown after operating income. Capital contributions should be reported
after nonoperating revenues and expenses as a separate line item.  Operating  income and expenses
should be appropriate for the nature of the activity, and should be disclosed as  a significant accounting
principle.  While interest revenues and expenses are not normally operating income items, they are for
the SRF since making  loans is the primary purpose of the program.  The statement of cash flows should
follow the  operating income policies used in the statement of revenues and expenses and changes in
fund net assets. The direct method  of presenting cash flows from operations should  be used, including
a reconciliation to operating income.


FUND TYPES AND BASIS OF ACCOUNTING

If GASB 34 is strictly and consistently applied by the states, there will be very few states that do not
account for the SRF as proprietary funds.  Nonetheless, there may be some SRFs that are not
accounted for as proprietary funds, and in those cases, understanding the basis of accounting and type
of fund is  essential in auditing the SRF financial statements. The type of fund (the measurement  focus)
determines what transactions and events are recorded and the basis of accounting determines when
and how those transactions are recorded.

The National Council of Governmental Accounting  (NCGA) Concepts Statement no. 1, Objectives of
Accounting and Financial Reporting for Governmental Units, concludes that the goals of governmental
accounting and financial reporting are to:

       (1) provide financial information useful for making economic, political, and social
       decisions, and demonstrating accountability and stewardship and (2) provide
       information useful for evaluating managerial and organizational performance.
              GASB Statement no. 14, The Financial Reporting Entity, discusses primary governments and component units.
               Financial presentation of these entities depends on the circumstances.

              GASB Statement no. 34, paragraph 92.

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An important element in achieving these goals is selecting of a basis of accounting and fund type for the
SRF that provides the necessary information to meet these goals. The basis of accounting and fund
type are intertwined. The basis of accounting used depends on the fund type, and the fund type may
determine the basis of accounting. Both will determine the accounting principles applicable to the SRF.
GASB 34 has substantial impacts on the fund type for the SRF and the basis of accounting to be  used.

Auditors should also keep in mind that a state may maintain its accounting records on one basis of
accounting, and prepare the financial statements of the SRF on a different basis.  Many states account
for all funds, including the SRF, on the cash basis during the year, and make adjustments to convert to
the  accrual or modified accrual basis for financial statement presentation to present the financial
statements according to GAAP.

Types of Funds.

In addition to selecting a basis of accounting for the SRF, states also use different types of funds  to
record SRF activity. The following section briefly describes the types of funds that may be encountered,
and distinctions between the types as they apply to the SRF.

Proprietary Funds. A proprietary fund is used to account for governmental activities that are similar to
commercial enterprises.  The two types of proprietary funds are Enterprise Funds and Internal Service
funds. Common examples of enterprise funds are airports, hospitals, state lotteries, state  insurance
funds, and public utilities, such as local water, sewer, and electric operations.  Internal service funds
operate the same, but provide goods and services only within the organization, such as motor pools,
data processing, and centralized maintenance.  General Services Administration is a good example of
an internal service fund.

Accounting for enterprise funds is similar to commercial enterprises  because the activities  performed are
basically the same.  However, the purpose of the fund is different. The purpose of a proprietary fund is
to provide a service to users at a reasonable cost, whereas the purpose of a commercial entity is  to
maximize its return on invested capital. Accounting and reporting for proprietary funds focuses on the
determination of operating income, changes in net assets, financial position, and cash flows.

Enterprise fund accounting works well for the SRF, and is the preferred fund type for the SRF.  The SRF
program was established as a permanent financing source in each state to provide financing to qualified
agencies at reduced interest rates. Since the SRF acts like a financing company or lending institution,
the  accounting should be similar.  The advantage to the proprietary fund is that all transactions, including
those of leveraged  funds, can be accounted for within a single fund. Having all transactions recorded in
one fund also facilitates financial reporting, and makes the financial statements easier to understand.

One of the more meaningful changes made by GASB no. 34 was to define what operations are required
to be accounted for as enterprise funds.  The focus of enterprise funds  is the determination of net
income, changes in net assets, financial position, and cash flows. GASB 34 states9:

       Enterprise funds may be used to report any activity for which a fee is charged to external
       users for goods or services. Activities are required to be reported as enterprise funds if
       any one of the following criteria is met. ..
       9       GASB statement no. 34, paragraphs 66 and 67.
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       a. The activity is financed with debt that is solely secured by a pledge of the net revenues from
       fees and charges of the activity10.

       b. Laws or regulations require that the activity's costs of providing services, including capital
       costs (such as depreciation or debt service) be recovered with fees and charges, rather than
       with taxes or similar revenues.

       c. The pricing policies of the activity establish fees and charges designed to recover its costs,
       including capital costs (such as depreciation and debt service). (Emphasis in original)

The SRF programs meet at least one, if not more (depending on how the  program is established), of
these requirements. The  SRF charges a fee (interest) to external users (borrowers) for goods or
services (financing). SRFs that issue revenue bonds, including state match bonds, payable solely from
the revenues of the SRF,  are required to be enterprise funds. In addition, several states charge a loan
fee or administrative fee intended to pay the administrative costs of operating the program, either
currently or in the future.  These states are now required to account for the SRF as an enterprise fund.

Nonexpendable Trust  Funds.  Nonexpendable trust funds are used to account for fiduciary
operations where the trust principal (capitalization grants) may not be expended and must remain
intact.  Earnings can either be expendable or nonexpendable. If used for an SRF, the earnings would
also be nonexpendable. A number of states account for SRFs as nonexpendable trusts. The
accounting is the same  as for enterprise funds. However, GASB 34 reclassifies most nonexpendable
trust funds as permanent  funds, and are to be included in the basic financial statements as
governmental funds, not as proprietary funds. As such, nonexpendable trusts may no longer be
appropriate for the SRF.

Special Revenue Funds. Special revenue funds are established to account for the proceeds of a
specific revenue source (other than special assessments, expendable trusts or sources for major
capital projects) that are legally restricted to expenditures for specified purposes. Examples of special
revenue funds would be a state gasoline tax for which expenditures are restricted for road and highway
maintenance, and a school district that is financed partially by property taxes.  The NCGA recommends
that special revenue funds be used  only when legally mandated.

Many states account for the SRF as a special revenue fund, primarily because the SRF replaced the
construction grant program, and these states merely continued accounting for the SRF as they did the
construction grants program. However, special revenue funds are generally not appropriate for SRF
operations because they do not easily allow for recording loans and other assets and liabilities of the
SRF.  If loan fees are charged to borrowers, GASB 34 requires reporting as an enterprise fund.

General Fund. Use of  a general fund to account for a SRF is the least desirable option.  However, at
least one state has operated its SRF as part of a general fund in the past. The purpose of a general
fund is to account for all financial resources of an entity except for those resources that cannot be
accounted for in another fund. The general fund is not used to account for fixed assets, long-term debt,
trust and agency funds, proprietary funds, or special revenue funds. General funds normally use the
modified  accrual basis of accounting.  The measurement focus for the general fund is to determine
what transactions and events should be recorded, and identify the net financial resources available for
appropriation and expenditure.
       10      Debt secured by net revenues and the full faith and credit of the primary government is not payable solely from
               fees and charges of the activity, even if the government is not expected to make any payments. Some debt
               may be secured, in part by a portion of its own proceeds, but should be considered as payable solely from the
               revenues of the activity.

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The general fund accounts for the current operations of the government. Expenditures are generally
for basic governmental services such as public safety, health and welfare, and general government
administration, such as accounting, auditing, building departments, data processing and similar
activities.  Revenues for the general fund usually are derived from income taxes, property taxes, sales
taxes, fines and penalties, permits  and licenses, and other sources.

Basis of Accounting. The basis of accounting determines when revenues, expenses, expenditures,
and transfers are recorded in the accounting records and reported in the financial statements. The
three primary bases of accounting  encountered are cash, accrual, and modified accrual. Most
governmental entities use all three, as different funds have different reporting needs, and  a different
measurement focus.

Cash.  Under the cash basis, receipts are recorded as revenues, and disbursements are recorded as
expenditures11.  The balance sheet has only two accounts-cash and fund  balance-and the operating
statement (income statement) has  only two accounts-revenues and expenditures.  The excess of
revenues over expenditures is closed to  fund balance at the end of the accounting  period.

The NCGA has concluded that cash is not an appropriate basis of accounting for governmental
organizations. Fortunately, states that use the cash basis of accounting also maintain records of loans
made and repayments.  With such  supplemental information, the states are able to prepare SRF
financial statements on the modified accrual method. If the accounting  is maintained on the cash
basis, it will be necessary for the state to modify the SRF financial statements to reflect a presentation
of financial information on the accrual or modified accrual bases.

Accrual. The accrual basis reflects the financial effects of transactions and other events that have
financial consequences in the period in which they occur rather than in the periods  in which the cash is
received or paid. The elements of accrual accounting include:

         Properly matching revenues earned against costs incurred;

         Deferring expenditures and subsequent amortization of deferred costs;

         Deferring revenues until  earned (revenues received in advance);

         Capitalization of certain expenditures and depreciation of capitalized costs, and;

         Accruing revenues earned and expenses incurred.

Very few governmental agencies use the full accrual basis because measuring income is  not the
primary objective of governmental entities.  However, most proprietary funds use the accrual method of
accounting because measuring the results of operations is the  primary objective. GASB 34 requires
government -wide financial statements to be prepared using the accrual method of accounting.

Modified Accrual.  Most government entities use a combination of the cash and accrual basis known
as the modified accrual basis. The modified accrual basis is appropriate because the primary objective
of accounting for governmental funds is to  reflect the sources and uses of funds, and not to measure
income  for the period. The modified accrual basis records revenues (including issuance of debt and
               The term expenditures is used to indicate decreases in the financial resources (or increases in
               current liabilities).  Expenditures can be for capital items, such as constructing new buildings, or
               operating expenditures, such as salaries and benefits. Expenditures of a governmental entity are
               not the same as expenses of a commercial enterprise.

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funds received for other governmental units) when they are susceptible to accrual. In order to be
susceptible to accrual, it needs to be both measurable and available to finance current expenditures.

For example, interest on loans that has not been received (this assumes loan payments are made
once or twice per year) would be accrued at the end of the year because it meets both criteria: interest
is measurable and will available to meet obligations of the current period. The calculation would be
made on the principal balance after the last payment, the number of days from the date of the last
payment to the end of the year, multiplied by the interest rate.  Most expenditures, such as salaries,
supplies and other administrative expenses, would be accrued because they are measurable when
incurred. However, loan funds committed but not fully paid out to a loan recipient at year end would
not be accrued because the loan agreement could be canceled.
AUDIT CONSIDERATIONS

The basis of accounting and fund type address when transactions are recorded and what transactions
are recorded.  Regardless of the state's basis of accounting and fund type, there are certain common
audit considerations for all SRF financial statements.

Cash and cash equivalents, loans receivable, contributed capital and fund balances, and revenues
and expenses are material accounts to the SRF financial statements.  Conceptually, common audit
procedures (not audit steps) can be applied, regardless of the accounting or fund type.

Materiality.  The concept of materiality recognizes that some matters  are important for the financial
statements to be presented fairly, in conformity with  GAAP, while other matters are not.  Financial
statements are materially misstated when the effects of the item (or items) cause the financial
statements not to be fairly presented, and would make probable that someone relying on the financial
information would make a different conclusion if the  statements were not misstated.  Misstatements
can occur because of errors, the failure to apply accepted accounting  principles, departures from fact,
or omissions of necessary information.

Determining what is material is a matter of professional judgment that will vary depending on the state
and the circumstances. What is material to one state may not be material to another. What is material
in one year may not be material in another year.  Auditors should plan the audit and perform auditing
procedures so that the risk of a  material misstatement is at a  low level.

Cash and Cash  Equivalents.  Auditing cash depends primarily on how the SRF is organized.  If cash
is controlled by a state treasurer (or similar department separate from SRF operational management),
SRF management may have little or no involvement in the actual disbursement of cash.  If the SRF is
a separate agency or authority,  its cash may be totally controlled (including disbursement) by SRF
personnel.  In the latter situation, the cash may be with a commercial bank, and risk of misstatement
of cash balances could be substantially increased.

The objective of auditing  cash is to obtain reasonable assurance that:

        The recorded balances exist and are owned by the SRF;

        The recorded balances are complete and  stated at realizable amounts;

        Balances are properly presented in the financial statements;

        Restrictions on the availability or use of cash are identified and disclosed, and;
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        Cash receipts, disbursements and transfers between accounts are recorded in the proper
       period.

The specific audit steps and procedures will depend on the circumstances, but generally include:

        Obtaining a schedule of cash for the SRF ;

        Making sure the cash balances agree with the trial balance;

        Reviewing and testing reconciliations at the balance sheet date;

        Confirming cash balances and interest earnings with the bank, state treasurer or other
       department responsible for cash;

        Reviewing and testing transactions before and after the balance sheet date to determine if
       the transactions are in the proper period, and;

        Reviewing and testing transfers between accounts.

Additional procedures would be involved if the SRF has accounts with commercial banks. Auditors
may want to obtain cut-off statements to review checks that were outstanding at the balance sheet
date that cleared after year end,  and determine that cash was properly stated.  If there are multiple
bank accounts, transfers between accounts should be scrutinized to determine if all transactions are
legitimate, and properly recorded.

Disclosures: Cash and cash equivalents need to disclosed in SRF financial statements according to
GASB Statement No. 3, Deposits with Financial Institutions, Investments [Including Repurchase
Agreements] and Reverse Repurchase Agreements. Also, some cash balances may be restricted, and
not available for the operations of the SRF.  The terms of any restrictions, such as uses or collateral for
other activities, should be fully investigated and disclosed.

Cash  may also include investments of excess cash, often called "cash equivalents." Whether the cash
is a cash equivalent will depend on the particular investment.  The type of investment, terms,
conditions, maturity and availability will govern whether the investment is cash or not. Typically, money
market funds, excess funds with the state treasurer, certificates of deposits and similar investments are
considered cash.

Loans Receivable. Loans receivable will normally be the  most significant asset of the SRF, and also
generate the largest portion of revenues. Loans should be reviewed to determine how: (1)
construction period interest is calculated; (2) such interest affects the final loan amount; and (3) the
transaction is reported in the SRF financial statements.

The objectives of the audit procedures performed are to provide reasonable assurance that:

        Loans exist at the stated values and are owned by the SRF;

        Loans are properly classified, described and disclosed in the financial statements;

        Recorded loans include all such assets of the SRF, and the financial statements include all
       related transactions during the period;
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        Interest income, fees and costs and the related balance sheet accounts (accrued interest
       receivable, unamortized fees and costs, unamortized premiums or discounts) are properly
       measured and recorded, and;

        Commitments, guarantees, recourse provisions and collateral are properly disclosed.

Basic audit procedures for loans receivable would include:

        Obtaining a schedule of loans at the balance sheet date;

        Inspecting loan documents to determine whether the loan was properly approved, and
       includes the amount, terms, fees, interest rates, purpose, repayment terms, and other
       conditions;

        Reviewing draws on loans and calculations of interest earned and accrued;

        Confirming loans and terms with borrowers;

        Performing analytical procedures on the loan  portfolio to indicate trends or possible collection
       problems, and;

        Reviewing loans and loan activity to determine if all loans are collectible. If not, an allowance
       for uncollectible loans should be established.

If loan fees are charged by the SRF, FASB Statement No. 91, Accounting for Nonrefundable Fees and
Costs Associated with  Originating or Acquiring Loans and Initial Direct Costs of Leases, which has
been  incorporated by GASB 10, Accounting and Financial Reporting for Risk Financing and Related
Insurance Issues, will apply. Basically, FASB 91 requires any fees to be accounted for as an
adjustment of the stated interest rate.  Many states charge fees for various purposes.  FASB 91 and
GASB 10 are not applicable only to the banking industry; they are applicable to all loans entered into
by a creditor agency.

For leveraged programs, the procedures may vary because the SRF acts as security or guaranty of
the borrowers debt, and the  audit procedures would need to be expanded to cover the circumstances.

Disclosures: Disclosures for loans  receivable should include:

        Major groups of loans (leveraged versus direct, completed loans and loans in progress);

        The interest rates and method of recognizing  interest income, including loan fees and costs;

        A schedule of principal repayments due by year for next five years, and by five year
       increments for the remaining balance;

        Major loan recipients, and;

        A discussion  of the allowance for uncollectible accounts (or a statement that management
       considers all loans fully collectible).

There may be other factors that need to be disclosed. For example,  if a major loan was refinanced or
restructured, the details would need to be fully disclosed.
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Fund Equity (Net Assets). GASB 33 and GASB 34 have changed how entities account for and report
capital contributions and fund balances.  GASB 33 establishes the standards for accounting for
nonexchange transactions involving financial or capital resources. GASB 33 addresses the timing of
when a nonexchange transaction occurs, and when the transaction should be recorded. GASB 34
establishes financial reporting standards for state and local governments, including special-purpose
governments. This guide is not an in-depth study or evaluation of either pronouncement,  but is to
identify relevant portions of both and the standards that apply to the SRF program.

A significant change made by GASB 34 is in reporting net assets/fund equity. Net assets should be
shown in three components: invested in capital assets, restricted, and unrestricted.  Contributed capital
is not to be shown with separate components, such as EPA contributions and state contributions, on
the statement of net assets.  For the SRF, the most common designations will be restricted net assets,
which are amounts to be used for debt service and interest payments and cannot be used for other
purposes, and unrestricted.

Nonetheless,  auditing fund equity is a critical aspect of SRF audits. It is not possible to determine if
fund equity is  fairly stated without determining the elements that cause fund equity to change from one
year to the next.  The specific steps involved will vary depending on each situation.  However, common
procedures would include:

        Total EPA capitalization grants awarded;

        Draws made on each grant;

        Total loans awarded, outstanding,  and  principal repaid;

        The  amount of state matching funds, and how the state match is made (direct contribution,
       bonds from within or outside the SRF),and;

        Any  accruals or adjustments made in prior years.

Some of this information (which should be obtained as part of normal audit procedures) can be
obtained from the Regional SRF Coordinator.  Auditors should confirm with the Regional SRF
Coordinator the total capitalization grants awarded and draws at the balance sheet date (and for the
first week or two following the balance sheet date). Other departments within the state may be able to
provide information that would also be helpful.

Disclosures: There are  a number of disclosures for equity that are useful for EPA and others in
managing the program.  Total capitalization grants awarded, draws to date, state matching funds (and
how state match is made) are all critical disclosures that should be either in the financial statements or
the notes. While GASB 34 does not allow the elements of fund equity to be disclosed on the balance
sheet, the elements (contributed capital from EPA, state match  contributions, and fund equity) should
be disclosed in the footnotes.  Additional disclosures will vary depending on the circumstances.  GASB
38 may require additional disclosures depending upon the particular situation.

Revenue and Expense Accounts. Revenue accounts for the SRF will primarily be interest earned on
loans, fees on loans, and investment earnings. Expenses will be for administering the program, and
include salaries and benefits, and other expenses.  For those programs that issue bonds, interest will
likely be a significant expense.

There are no specific  audit procedures that are unique to the  SRF for auditing revenues and expenses.
Specific procedures depend on  the situation involved.  Generally, interest income on loans can be
tested, confirmed and recalculated, as can interest expense.  Analytical procedures and trend analysis


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applied to various accounts and relationships can provide useful information to verify or substantiate
balances, and indicate possible misstatements

The statement of revenues and expenses now includes changes in net assets, not just fund balance.
Revenues should be reported by major source, and should identify revenues used as security for
revenue bonds.  It also distinguishes between operating and nonoperating revenues and expenses,
and should  report separate totals for operating revenues, operating expenses, and operating income.
Nonoperating income should be shown after operating income. Capital contributions should be
reported after nonoperating revenues and expenses as a separate line item.  Operating income and
expenses should be appropriate for the nature of the activity, and should be disclosed as a significant
accounting  principle.  While interest revenues and expenses are not normally operating income items,
they are for the SRF since making loans is the primary purpose of the program. The statement of cash
flows should follow the operating income policies used in the statement of revenues and expenses and
changes in fund net assets. The direct method of presenting cash flows from operations should be
used, including a reconciliation to operating income.

Other Accounts.  There will likely be other accounts on the balance sheet, such as accrued
receivables, investments receivable, accounts payable, accrued expenses and others. Leveraged
programs will normally involve more accounts, especially in cash and cash accounts with trustees.
Auditing procedures will vary, and depend on the account, amount, and other factors.  The auditor is
expected to use professional judgment in determining specific  procedures to  apply to all accounts.
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                                    CHAPTER 7

                           COMPLIANCE AUDITING

This chapter addresses the third audit objective: To determine whether the state has complied in all
material respects with laws, regulations, and the provisions of SRF capitalization grants. It provides
guidance on the compliance matters in SRF capitalization grants that should be addressed during the
audit. Compliance with these provisions allows EPA to effectively have some assurance over items
that they believe are important to the successful management of the program and legislative intent.
Since the significance of a particular compliance matter can vary from state to state, professional
judgment regarding the extent of compliance testing must be exercised.

BACKGROUND

The compliance auditing necessary to satisfy this objective is very similar to the compliance auditing
required by the Single Audit Act, set forth in standards for major programs in OMB Circular A-133 (A-
133), and identified in  OMB's Compliance Supplement to A-133 (the "Supplement"). In the
Supplement, EPA has outlined the compliance requirements that,  if not followed, could have a direct
and material impact on the SRF programs. This is a higher compliance reporting requirement than
required by GAGAS. GAGAS requires that audits of Federal programs be designed to "provide
reasonable assurance of detecting material misstatements of financial statements or other financial
data resulting from noncompliance with provisions of contracts or grant agreements that have a direct
and material effect on  the determination of financial statement amounts." Additional reporting
requirements are discussed in Chapter 8- Audit Completion and the Auditor's Report.

Specific requirements for the Clean Water SRF and the Drinking Water SRF can be found in Part 4
under the Catalog of Federal Domestic Assistance (CFDA) numbers 66.458 and 66.468, respectively.
The Supplement contains 14 areas of compliance requirements, 13 of which may be applicable to the
SRF programs.  Audit objectives and suggested audit procedures  for these areas are included in Part 3
of the Supplement.  Additional information on nine of these requirements is addressed in Part 4 of the
Supplement and is further discussed later in this Chapter. The OMB guidance also  states:

       Even though [the compliance matrix] indicates that the  compliance requirement
       applies to the Federal program, it may not apply at a particular non-Federal entity,
       either because that entity does not have activity subject to that type of compliance
       requirement or the activity could not have a material effect on a major program.

OMB recommends that auditors should use professional judgment when determining which compliance
requirements should be tested.
BUILDING ON THE WORK OF OTHERS

In planning the audit effort to satisfy the compliance audit objective, the auditor should determine
whether other auditors have performed work that will partially or completely satisfy the audit objective. In
particular, if an OMB Circular A-133 audit has been performed and the SRF was treated as a major
program, the work and workpapers of the A-133 audit should be reviewed.  In instances where the A-
133 audit was of the prior year, the work and workpapers can still provide valuable insight on the state's
compliance with SRF requirements.

Another source of compliance information is the annual review by the Regional SRF Coordinator. While
the annual review is not an audit, it often addresses SRF compliance matters and can assist the auditor

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in determining compliance aspects that may or may not be problem areas. Specific compliance
requirements that should be addressed in SRF audits are as follows (the designations parallel the OMB
Compliance Supplement.)


CLEAN WATER SRF COMPLIANCE REQUIREMENTS

A. Allowability for Specific Activities.

Audit Objective: To determine that SRF funds are used only for qualified projects, and that the type of
assistance provided is allowable.

The SRF may provide financial assistance: (1) to municipalities, inter-municipal, interstate, or State
agencies for the construction of publicly owned treatment works as defined in Section 212 of the Act that
are on the state's Project Priority List; (2) for implementing nonpoint source management programs
under Section 319 of the Act; and (3) for developing and implementing estuary management plans under
Section 320 of the Act.

There are five types of financial assistance that can be made to local agencies:

       1.  Loans (not grants)

       2.  Refinance existing  debt obligations.

       3.  The guarantee or purchase of insurance for local debt obligations.

       4.  The guarantee of or use as a source of repayment for SRF debt obligations (provided that
           the net proceeds of the sale of such bonds are deposited in the SRF).

       5.  Loan guarantees for similar revolving funds established by municipalities or intermunicipal
           agencies;

In addition, the SRF can be used to pay administrative expenses  incurred by the state for managing the
SRF (up to four percent  of the capitalization grants).  Any interest earned from SRF funds must be
deposited in the fund and used for these same activities.

B. Allowable Costs/Cost Principles.

Audit Objective: To determine that SRF administrative expenses (including indirect costs) are
reasonable and allowable in accordance with OMB Circular A-87  Cost Principles.

The SRF may be used for reasonable and allowable costs incurred  for administration and management
of the SRF program (subject to a limit equaling 4 percent of all capitalization grants received),  including
management of projects receiving financial assistance.

C. Cash Management.

Audit Objective: To determine that the state has drawn cash consistent with the SRF requirements.

The state must establish cash management procedures consistent with the intent of Congress. Cash
can only be drawn from  EPA for allowable expenses. The timing of the draws depends on the  type of
assistance, as follows:
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       1.   Loans - when the SRF receives a request from a loan recipient, based on incurred costs,
           including pre-building and building costs.

       2.   Refinance or purchase of municipal debt - generally, when at a rate no greater than equal
           amounts over the maximum number of quarters that payments can be made, and up to the
           portion of the LOG committed to the refinancing or purchase of the local debt.

       3.   Purchase of insurance - when insurance premiums are due.

       4.   Guarantees and security for bonds - immediately, in the event of imminent default in debt
           service payments on the guaranteed/secured debt.

       5.   Administrative expenses - cash can be drawn based on a schedule that coincides with the
           rate at which administrative expenses will be incurred (40 CFR 35.3160).

Recipients must follow procedures to minimize the time elapsing between the transfer of funds from the
U.S. Treasury and disbursement.

G. State Matching.

Audit Objective:  To determine  that the state provides the matching funds necessary and in a timely
manner to earn the capitalization grant.

States are required to provide a  match  of twenty (20) percent of each grant payment drawn from EPA on
or before the date on which the funds are drawn. The matching can be made by direct appropriation,
general obligation bonds, revenue bonds, or other  methods.

H. Period of Availability of Funds and Binding Commitments.

Audit Objective:  To determine  that grant funds are drawn timely and binding commitments are entered
into timely.

Grant funds are made available to the states according to a payment schedule (See Funding the SRFs
in Chapter 3) in the capitalization grant agreement. Generally, payments must start  in the quarter in
which the grant is awarded, and  end no later than eight quarters after the grant is awarded (40 CFR
35.3155(c)). Cash draw requirements are discussed at 40 CFR 35.3155(d). The date funds are
available from EPA leads to a special SRF compliance requirement, binding commitments. States must
enter into cumulative binding commitments of at least 120 percent of the cumulative capitalization grant
payments received one year earlier.

J.  Program Income.

Audit Objective:  To determine  that interest earned is credited to the SRF and any other program
income is used in accordance with program policy.

Interest earned is to be credited  to the SRF to increase the fund. Other income/fees (such as loan fees
or administrative fees charged on loans) generated by the operation of the SRF should be evaluated
against the requirements of 40 CFR 31.25.  EPA has established policies governing the use of program
income. Generally, program income generated in the SRF can only be used for allowable purposes,
including paying the operating expenses of the SRF.

L.  Reporting.
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Audit Objective:  To determine that required reports are submitted and in a timely manner.

The following reports must be submitted as required by the regulations and the grant agreements:

       1.   Intended Use Plan (40 CFR. Section 35.3150). The state must prepare an Intended Use
           Plan identifying the intended uses of funds of the SRF, and describe how those uses support
           the goals of the SRF.  The IUP must be prepared annually, and  must be subjected to public
           comment and review before being submitted to EPA.  An IUP that adequately describes the
           use of existing SRF funds as well as those being applied for must be submitted before a
           capitalization grant can be awarded.

       2.   Annual Report (40 CFR. Section 35.3165(a)). The state must provide an annual report to
           the EPA Regional Administrator according to the schedule in the grant agreement.  The
           Annual Report must establish that the state has: (1) reviewed all projects in accordance with
           the approved environmental review process, (2) deposited the matching funds as required,
           (3) complied with Title II requirements of the Act, (4) made binding commitments as required
           under 40 CFR 35.3135(c), and (5) expended all funds in an expeditious and timely  manner.
           The annual report should also include financial statements, a report on the internal  controls,
           and a  report on compliance with Title VI of the Act as required by the capitalization  grant
           agreements.

       3.   Financial Reports (40 CFR Section 31.41).  The state is  required to submit Financial Status
           Reports (SF-269) and Federal Cash Transaction Reports (SF-272).

M. Subrecipient Monitoring.

Audit Objective:  To determine that the state monitors loan recipients to ensure  that their project
accounting system used meets the SRF program requirements.

The state must require recipients of SRF assistance to maintain project accounts in accordance with
GAAP as issued by the Governmental Accounting Standards Board. The accounts must be maintained
as separate accounts.

N. Special Tests  and Provisions.

Environmental Review requirements:

Audit Objective: To determine whether the State is complying with the environmental reviews
requirements of 40 CFR Section 3140 before loan recipients initiate construction under projects.

The State must conduct reviews of the potential environmental impacts of all Section 212 construction
projects receiving assistance from the SRF, including nonpoint source pollution control and estuary
protection projects that are also Section 212 projects.

Fund Establishment:

Audit Objective:  To determine that the State has established proper accounts and accounting
procedures that are sufficient to assure proper accounting for SRF transactions and balances.

The State is to establish the  SRF as a separate account or series of accounts dedicated solely to
providing financial assistance in the form of loans and other assistance, but  not grants. The State must
establish fiscal controls and accounting procedures that are sufficient to assure proper accounting for
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payments received by the SRF, disbursements made by the SRF and beginning and ending account
balances (40 CFR 35.3115 and 40 CFR 35.3135).

Loan Repayments and Fund Earnings Credited to SRF:

Audit Objective: To determine whether principal and interest payments are properly credited to the
SRF.

All loan repayments, including principal and interest, and interest earnings on investments, must be
credited directly to the SRF. Repayment of loans must begin within 1 year after project completion, and
loans must be fully amortized over not more than 20 years after project completion. (40 CFR. Section
35.3120(a))

SRF as Security for Bonds:

Audit Objective: To determine whether the State has complied with requirements for guaranteeing SRF
debt obligations.

If a state uses the SRF as security or a source of revenue for the payment of principal and interest on
revenue or general obligation bonds issued by the State, the net proceeds of the sale of such bonds
must be deposited in the SRF (40 CFR. Section 35.3120(d)). Net proceeds are defined as the funds
raised from the sale of the bonds minus issuance costs.
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DRINKING WATER SRF COMPLIANCE REQUIREMENTS

A. Allowability for Specific Activities.

Audit Objective: To determine that DWSRF funds are used only for qualified projects, and
that the type of assistance provided is allowable.

The DWSRF may provide financial assistance: (1) to privately-owned and publicly-owned community
water systems and non-profit noncommunity water systems, (2) projects that will result in the creation of
a community water system and, (3) systems referred to in section1401  (4)(B) of the Safe Drinking Water
Act for purposes of point of entry or central treatment under section 1401(4)(B)(i)(lll).

Projects that address present or prevent future violations of health-based drinking water standards are
eligible for assistance, which includes projects needed to maintain compliance with existing national
primary drinking water regulations for contaminants with acute and chronic health effects. The following
project categories are eligible for assistance:

       1.  Treatment facilities;

       2.  Transmission and distributions facilities;

       3.  Source water projects such as the rehabilitation of wells or development of eligible sources
           to replace contaminated  sources;

       4.  Storage facilities;

       5.  Consolidation of water supplies; and

       6.  Creation of new community water systems to address existing public water health problems.

There are five types of financial assistance that can  be made to local agencies:

       1.  Loans;

       2.  Loan subsidies to disadvantaged communities. Subsidies can include full or partial principal
           forgiveness, negative interest rates, extension of the loan repayment period to 30 years
           (provided that the repayment term does not exceed the expected useful life of the project),
           or a combination of the above;

       3.  Refinance or purchase local debt obligations for projects initiated after July 1, 1993;

       4.  Purchase insurance for or guarantee local debt obligations;

       5.  Use revenues or otherwise provide security for debt obligations of the loan fund, provided
           the net proceeds of the sale of the debt obligations are deposited into the loan fund and
           used to provide assistance eligible under the Act.

States may also use a portion of its capitalization grants for set-aside activities. These uses and
limitations of these activities are covered in section B, Allowable Costs/Cost Principles.
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B.  Allowable Costs/Cost Principles.

Audit Objective: To determine that DWSRF administrative expenses and set-aside activities (including
indirect costs) are reasonable and allowable in accordance with OMB Circular A-87 cost principles.

The uses of set-asides from the capitalization grant are:

       1.   4 percent to administer the DWSRF program and provide technical assistance to public
           water systems;

       2.   2 percent of to provide technical assistance to small public water systems;

       3.   10 percent for state program management activities, including administration of the State
           Public Water System Supervision Program, administration of the source water protection
           program, development and implementation of the capacity development and operator
           certification programs;

       4.   15 percent to assist in the development and implementation of local drinking water
           protection initiatives and other State programs.


C. Cash Management.

Audit Objective: To determine that the state has drawn cash consistent with the DWSRF requirements.

The state must establish cash management procedures consistent with the intent of Congress. Cash can
only be drawn from EPA for allowable expenses. The timing of the draws depend on the type of
assistance, as follows:

       1.   Loans - when the DWSRF receives a request from a loan recipient,  based on incurred costs,
           including pre-building and building costs.

       2.   Refinance or purchase of municipal debt - generally, when at a rate  no greater than equal
           amounts over the maximum number of quarters that payments can be made, and up to the
           portion of the LOG committed to the refinancing or purchase of the local debt.

       3.   Purchase of insurance - when insurance premiums are due.

       4.   Guarantees and security for bonds - immediately, in the event of imminent default in debt
           service payments on the guaranteed/secured debt.

       5.   Administrative and other set-aside expenses - cash can be drawn based on a schedule that
           coincides with the rate at which administrative expenses will be incurred (40 CFR
           35.3560(e)).

Recipients must follow procedures to minimize the time elapsing between the transfer of funds from the
U.S. Treasury and disbursement.

G. State Matching.

Audit Objective: To determine that the state provides the required matching funds in  a timely manner.

States are required to deposit into the SRF a match of at least twenty (20) percent of each capitalization
grant payment made. If the State uses a letter of credit or similar instrument, they may deposit the

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proportionate share of match on or before the date an EPA cash draw is received.  The proportionate
share of state match is equal to the State match required for the SRF divided by the total amount of
monies intended for the SRF (capitalization grant minus set-asides plus State match). The matching can
be made by direct appropriation, general obligation bonds, revenue bonds, or other methods.

H. Period of Availability of Funds and Binding Commitments.

Audit Objective: To determine that grant funds are drawn timely and binding commitments are entered
into timely.

Grant funds are made available to the states according to a payment schedule (See Funding the
DWSRF in Chapter 3) in the capitalization grant agreement. Generally, payments must start in the
quarter in which the grant is awarded, and end no later than eight quarters after the grant is awarded [40
CFR 35.3550(d)].  Cash draw requirements are discussed at 40 CFR 35.3560. States must enter into
cumulative binding commitments of at least the amount of the cumulative capitalization grant payments
for the SRF (excludes set-aside funds) received one year earlier and the corresponding state match
required to be deposited into the loan fund.

J. Program Income

Audit Objective: To determine that interest earned is credited to the loan fund and any other program
income is used in accordance with DWSRF regulations.

Interest earned is to be credited to the loan fund. Other income/fees generated by the operation of the
DWSRF should be evaluated against the requirements of 40 CFR 35.3530(b) and 40 CFR 31.25.

L.  Reporting.

Audit Objective:  To determine that required reports are submitted and in a timely manner.

The following reports must be submitted as required by the regulations and the grant agreements:

       1.   Intended Use Plan (40 CFR 35.3555).  The state must prepare an Intended Use Plan
           identifying the intended uses of funds of the DWSRF, and describing how those uses
           support the goals of the DWSRF. An IUP that adequately describes the use of existing SRF
           funds as well as those being applied for must be submitted before a capitalization grant can
           be awarded.

       2.   Biennial Report [40 CFR 35.3570(a)].   The state must provide a biennial report to the EPA
           Regional Administrator describing how it has met the goals and objectives of the previous
           two fiscal years as stated in the lUPs and capitalization grants.  These biennial reports
           should contain the most recent audit of the Fund and the entire State allotment.  The state
           must establish in the biennial report that is has complied with section 1452 of the Act,
           including that the state has  (1) managed the DWSRF program in a fiscally prudent manner,
           (2) deposited its match into  the Fund, (3) made binding commitments with recipients
           consistent with the requirements, (4) funded only the highest priority projects listed in the
           IUP or document why priority projects were bypassed, (5)  provided assistance only to
           eligible public water systems for eligible projects and project-related costs, (6) provided set-
           aside assistance only as eligible under section 35.3535 and consistent with workplans and
           other requirements, (7) provided loan assistance to small communities consistent with
           35.3525(a)(5) and  35.3555(c)(2)(iv), provided assistance to disadvantaged communities
           consistent with 35.3535(b) and 35.3555(c)(7), (8) Adopted and implemented procedures
           consistent with the requirements of  35.3530(c) and  35.3555(c)(8) if funds were

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           transferred between the DWSRF program and CWSRF program, (9) reviewed all DWSRF
           program funded projects and activities for compliance with Federal crosscutters, (10)
           reviewed all DWSRF program funded projects and activities in accordance with approved
           State environmental review procedures under 35.3580; and (11) complied with general grant
           regulations at 40 CFR part 31.

M. Subrecipient Monitoring.

Audit Objective: To determine that the state monitors loan recipients to ensure that their project
accounting system used meets the DWSRF program requirements.

The state must require recipients of DWSRF assistance to maintain project accounts in accordance with
GAAP as issued by the Governmental Accounting Standards Board. The accounts must be maintained
as separate accounts.

N. Special Tests and Provisions.

Environmental Review Requirements:

Audit Objective: To determine whether the state is complying with the environmental reviews
requirements of 40 CFR 35.3580 before loan recipients initiate construction under projects.

The state must conduct reviews of the potential environmental impacts of all construction projects
receiving assistance from the DWSRF

Fund Establishment:

Audit Objective: To determine that the state has established proper accounts and accounting
procedures that are sufficient to assure proper accounting for DWSRF transactions and balances,
including the loan fund and all set-aside funds.

The state is to establish the DWSRF and the set-asides as a separate account or series of accounts
dedicated solely to providing financial assistance in the form of loans and other eligible assistance. The
state must establish fiscal controls and accounting procedures that are sufficient to measure (1)
revenues earned and other receipts, including but not limited to, loan repayments, capitalization grants,
interest earnings, state match deposits, and net bond proceeds; (2) expenses incurred and other
disbursements, including but not limited to, loan disbursements, repayments of bonds, and other
expenditures allowed under section 1452 of the Act; (3) assets, liabilities, capital contributions and
retained earnings.


Loan Repayments and Fund Earnings Credited to  DWSRF:

Audit Objective: To determine whether principal and interest payments are properly
credited to the DWSRF.

All loan repayments, including principal  and interest, and interest earnings on investments, must be
credited directly to the DWSRF. Repayment of loans must begin within 1 year after project completion,
and loans must be fully amortized over not more than 20 years after project completion [40 CFR
35.3525].  Loans to disadvantaged communities may be repaid over 30 years, or the estimated  useful
life of the project, whichever is shorter.
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DWSRF as Security for Bonds:

Audit Objective: To determine whether the state has complied with requirements for guaranteeing
DWSRF debt obligations.

If a state uses the DWSRF as security or a source of revenue for the payment of principal and interest
on revenue or general obligation bonds issued by the state, the net proceeds of the sale of such bonds
must be deposited in the DWSRF. Net proceeds are defined as the funds raised from the sale of the
bonds minus issuance costs.
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                                     CHAPTER 8

                              AUDIT COMPLETION

                       AND THE AUDITOR'S REPORT

Completion of the audit after conducting the fieldwork involves: (1) obtaining a representation letter from
the state; (2) presenting the results of audit to the state; and (3) issuing the auditor's report.

REPRESENTATION LETTER

GAGAS requires that the auditor obtain written representations from management as a part of the audit.
The auditor obtains written representations from management to complement other auditing  procedures.
Written representations ordinarily confirm oral representations given to the auditor, indicate and
document the continuing appropriateness of such representations, and reduce the possibility of
misunderstandings concerning the matters that are the subject of the representations. SAS No. 19,
Client Representations, provides guidance to assist the auditor in the content and timing of
representations.

Normally, the auditor prepares the representation for management to sign, and works with management
to arrive at a mutually acceptable representation letter.  However, the representation letter is
management's and should be addressed to  the auditor. Because the auditor is concerned with events
occurring through the date of the auditor's report, the representations should be dated as of the date of
the auditor's report. It should be signed by members of management whom the auditor believes are
responsible for and knowledgeable, directly  or through others in the organization, about the matters
covered by the representations.  Management's refusal to furnish written representations constitutes a
limitation on the scope of the audit sufficient to preclude an unqualified opinion.

A sample representation letter is included as Appendix E.

PRESENTING THE RESULTS OF AUDIT

In accordance with GAGAS and OIG  policies, the state should be kept informed about the audit progress
and tentative findings throughout the  audit.  At the completion of fieldwork, the auditor should conduct a
preliminary exit conference to convey the tentative results of audit.

The letter transmitting the draft report should request comments on the factual accuracy of the auditor's
findings, and the state's reaction to the  auditor's recommendations.  Because the SRF financial
statements are management's, any auditor adjustments or footnotes considered (by the auditor) as
material to the statements  must be accepted by management. Otherwise, the auditor's opinion on the
financial statements may require qualification.

The letter transmitting the draft report should provide a date for receipt of management's  comments, and
indicate that a final exit conference will  be held after receipt and evaluation of management's comments.

The exit conference should be scheduled to present the final results of audit to management, receive
any final comments from the state, and  advise management on the expected issuance date for the
auditor's report. The exit conference is also an  excellent opportunity to advise management regarding:
(1) matters observed by the auditor during the audit that could improve internal controls or efficiency,
effectiveness, and economy of the operation of the SRF program but which do not warrant inclusion in
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the auditor's reports; and (2) procedures for resolving compliance issues or other matters.  Other
interested parties, such as the Regional SRF Coordinator, are encouraged to attend the exit conference.
THE AUDITOR'S REPORT

The auditor's report is normally addressed to the state's management responsible for the SRF. It
includes three components:

        Financial statements with an opinion (or disclaimer of opinion) as to whether the SRF financial
       statements are presented fairly in all material respected in conformity with GAAP.

        A report on internal controls related to the SRF financial statements. The report should
       describe the scope of testing  of internal control and the results of tests, and, where applicable,
       refer to a separate schedule of findings and/or costs questioned.

        A report on compliance that includes an opinion as to whether the state has complied in all
       material respects with laws, regulations, and the provisions of the SRF capitalization grants.

The auditor's report is also transmitted to EPA for resolution of audit findings. Reports on compliance
and internal controls may be separate or combined. The auditor should decide which  format is
appropriate under the circumstances.

A sample auditor's report is included as Appendix F.

Reports on Compliance. A major aspect of EPA's oversight of the SRF programs is  to determine if
states have complied in all material respects with laws, regulations, and the  provisions of SRF
capitalization grants. Reports on compliance allow EPA to receive some assurance that states are
complying with matters that are important to the successful management of the program.

GAGAS requires that audits of Federal programs be designed to "provide reasonable assurance of
detecting material misstatements of financial statements or other financial data resulting from
noncompliance with provisions of contracts or grant agreements that have a direct and material effect on
the determination of financial statement amounts."  While GAGAS requires auditors to report the scope
of the testing of compliance with laws and regulations and of internal controls when performing financial
statement audits, the 2002 Revision (Exposure Draft) states:

       Auditors should report the scope of their testing of compliance with laws and
       regulations and of internal control over financial reporting, including whether or not
       the tests they performed provide  sufficient evidence to support an opinion on
       compliance with laws and regulations or internal control over financial reporting and
       whether they are providing such opinions.

Auditors had been able to disclaim opinions  on compliance because the objective of an audit was to
express an opinion on the financial statements, not on compliance with applicable laws,  regulations,
contracts, and grant provisions.

However, this guide establishes that one of the principal objectives of auditing the SRF is to
determine if the state complied with the compliance requirements. As such, disclaimers of
opinion on compliance are not acceptable.  Opinions on compliance must be unqualified, qualified,
or an adverse opinion.  Auditors should ensure that the testing of compliance is sufficient to allow them
to issue an opinion on compliance.  If auditors plan the audit and design tests to address the compliance
requirements listed above, an opinion on compliance can be issued.


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Reporting Requirements: The content of the compliance reports will depend on the conditions noted.
Material instances of noncompliance must be reported.  Material noncompliance are those instances that
could cause auditors to conclude that misstatements from those violations are material to the financial
statements. Such instances could include the failure to follow program requirements, violations of
statutes, regulations, or contract terms; or could also include irregularities and other illegal acts.  When
material instances of noncompliance are discovered, the report should include:

        Identification of the material noncompliance noted;

        A statement that the noncompliance was considered in forming an opinion on whether the
       financial statements are presented fairly, in all material respects, in conformity with generally
       accepted accounting principles, and;

        Identify and question any costs as a result of the noncompliance.

This guide establishes the reporting requirements for audits of SRFs, and AICPA standards require that
reporting for program-specific audits follow the reporting requirements of program-specific Federal audit
guides.  The AICPA has established formats for reporting that should be followed by all auditors, and
issued SOP 98-3 (Statement of Position) for the reporting requirements of A-133.

For states that currently conduct audits of the SRF, the state must ensure that the audits are performed
in accordance with  GAGAS and this guide, and contain the required reports, whether the audit is
performed by an outside auditing firm or state auditors.

This guide does not modify the auditor's responsibilities  concerning reporting on irregularities, illegal
acts, or other material noncompliance.  Auditors should follow GAGAS and published AICPA guidance if
irregularities,  illegal acts, or other material noncompliance is discovered.
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Appendix A

Reference Material

SRF Program

       Clean Water Act (Title VI), as amended by the Water Quality Act of 1987.

       Safe Drinking Water Act Amendments of 1996 (Title I)

       40 CFR Part 35, Subpart K - State Water Pollution Control Revolving Funds

       40 CFR Part 35, Subpart L - Drinking Water State Revolving Funds

       EPA's Initial Guidance for State Revolving  Funds, January 1988

       EPA's Guide to Using EPA's Automated Clearing House for the Drinking Water State Revolving
       Fund Program, September 1998 (available for download atwww.epa.gov)

       SRF Correspondence12

Professional Audit Pronouncements

       Government Auditing Standards, Comptroller General of the United States

       Pronouncements by the AICPA, Financial Standards Board

       Pronouncements by the Governmental Accounting Standards Board

       AICPA Audit and Accounting Guide, Audits of State and Local Governments, May 1, 1996

       AICPA Audit and Accounting Guide, Consideration of Internal Control in a Financial Statement
       Audit, April 1, 1996

Other Reference Material

       Single Audit Act, as amended

       OMB Circular No. A-133

       OMB Circular No. A-133 Compliance Supplement, March 2002
       12      EPA's Office of Water has compiled a listing of correspondence relevant to the SRF. Auditors
              should contact the SRF Coordinator in their region to obtain the listing and the desired
              correspondence.

                                       Appendix A-Page 5

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Appendix B

Sample Engagement Letter
Date

Addressee

Re:    Audit of Financial Statements of State Revolving Fund

Dear:

This is to confirm our arrangements for [name of firm] to conduct an audit of the financial statements of
the XXXXXX State Revolving Fund (SRF) as of [balance sheet date]. The purpose of our audit is to:

         express an opinion on the fairness of the financial statements prepared by the State of
       XXXXXX, and to conclude whether such statements are prepared in accordance with generally
       accepted accounting principles;

        report on the internal controls related to the financial statements of the SRF.  The report will
       describes the scope of testing of the internal controls, the results of those tests, and  if applicable,
       refer to a separate schedule of findings and/or costs questioned, and;

        report on compliance that includes an opinion as to whether the state has complied, in all
       material respects, with laws, regulations, and provisions of the SRF capitalization grants.

Our audit will  be made in accordance with generally accepted government auditing standards applicable in
the United States and will include tests of your accounting records and other procedures we consider
necessary to enable us to express an opinion that the financial statements of the State Revolving Fund
are fairly presented,  in  all material respects.  Our procedures will include tests of documentary evidence
supporting the transactions recorded in the accounts, direct confirmation of cash balances, loans
receivable and certain other assets and liabilities with selected communities or districts, and other parties
as necessary. We will  also request written representations from you about the financial statements and
related matters.

We understand that you will  provide us with basic information required for us to conduct our audit, and that
you are responsible for the accuracy and completeness of that information. We will advise you about
appropriate accounting principles, their application, and the preparation of your financial statements, but
the responsibility for the financial statements is with the State of XXXXXX.

As discussed with you, we will start our examination on date. In order to facilitate the examination, we
would appreciate it if you could have certain information and schedules available prior to our arrival.
Specifically, we will require:

         Financial statements for the SRF as of [balance sheet date], a trial balance and chart of
       accounts;

        A detailed schedule of existing loans at [balance sheet date, including dates of loans, original
       loan balance, loan balance at [balance sheet date, repayment terms, and interest rates;

        A schedule of binding commitments made as of [balance sheet date;
                                        Appendix B-Page 1

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        Copies of the state legislation establishing the SRF, operating agreements, memorandums of
       understanding with other departments or agencies;

        Copies of all capitalization grant agreements, including amendments, awarded by the
       Environmental Protection Agency through [balance sheet date];

        Access to minutes of the Board, and;

        An organization chart of the SRF, plus job descriptions for all personnel.

We will also require that you prepare several confirmations letters that we can use to confirm loans, cash
in the state treasury, attorney's letters, and a representation letter.

If you should have any questions, please contact me at (999) 999-9999 or [Supervisor/AIC] at (999) 999-
9998.
Sincerely,
                                         Appendix B-Page 2

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Appendix C

Internal  Control Review Process

The attached flowchart identifies the processes discussed in the SRF Audit Guide, Planning and Internal
Controls, in reviewing and reporting on internal controls in a financial statement audit.
      MANAGEMENT
       ASSERTIONS
     Existence or Occurrence
     Completeness
     Rights and Obligations
     Valuation or Allocation
     Presentation and Disclosure
                     J
  Gain Understanding of
  Organization, Management and
  Accounting Policies
INTERNAL CONTROL
   STRUCTURE
OBTAIN UNDERSTANDNG
OF INTERNAL CONTROLS
ASSESSING CONTROL RISK
  (EVALUATE INTERNAL
      CONTROLS)

^


TEST INTERNAL CONTROLS




Conduct Tests


>

EVALUATE RESULTS &
DETERMINE SUBSTANTIVE
PROCEDURES
1
Effectiveness of
design of controls
1


>

REPORT RESULTS



           - Transaction Testing
           -Interviews
           -Walkthroughs
           - Observations
                                             Appendix C-Page 1

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Appendix D

Financial Statement Assertions and Potential Misstatements

This appendix is provided to identify each financial statement assertion, and the potential misstatements
that could occur in each assertion in an accounting application. Specific control objectives are also
presented to assist is assessing the control risk associated with each assertion. This information should
be tailored to the specific state and accounting application, and can be supplemented with other control
objectives as the situation dictates.  This section is provided only as a reference to assist auditors in
reviewing and assessing the internal controls over the SRF.
                                       Appendix D-Page 1

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Financial Statement Assertions and Potential Misstatements
 ASSERTION
           POTENTIAL
         MISSTATEMENT
        CONTROL OBJECTIVE
 Existence or
 Occurrence
Transaction-Related

Validity:
1. Recorded transactions do not
represent economic events that
actually occurred.
                      2. Transactions are recorded in the
                      current period, but the related
                      economic events occurred in a different
                      period.

                      Summarization:
                      3. Transactions are summarized
                      improperly, resulting in an overstated
                      total.

                      Line Item/Account-Related

                      Substantiation:
                      4. Recorded assets and liabilities do
                      not exist at a given date
1a. Recorded transactions, underlying events,
and related processing procedures should be
authorized by federal laws, regulations, and
management
policy.

1b. Recorded transactions should  be
approved by appropriate individuals in
accordance with management's general or
specific criteria.

1c. Recorded transactions should  represent
events that actually occurred and should be
properly classified.

2. Transactions recorded  in the current period
should represent economic events that
occurred during the current period.
                                    3. The summarization of recorded
                                    transactions should not be overstated
                                    4a. Recorded assets and liabilities should
                                    exist at a given date.

                                    4b. Recorded assets and liabilities of the
                                    entity, at a given date, should be supported by
                                    appropriate detailed records which are
                                    accurately summarized and reconciled to the
                                    account balance.

                                    4c. Access to assets, critical forms, records,
                                    and processing and storage areas should be
                                    permitted only in accordance with laws,
                                    regulations, and management policy.
                                          Appendix D-Page 2

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ASSERTION
           POTENTIAL
         MISSTATEMENT
        CONTROL OBJECTIVE
Completeness
Transaction-Related

Transaction Completeness:
5. Valid transactions are not
recorded.

Cutoff:
6. Economic events occur in the
current period, but the related
transactions are recorded in a different
period.

Summarization:
7. Transactions are summarized
improperly,  resulting in an understated
total.

Line Item/Account-Related

Account Completeness:
8. Assets and liabilities of the entity
exist but are omitted from the financial
statements.
5. All valid transactions should be recorded
and properly classified
                                                          6. All economic events that occurred in the
                                                          current period should be recorded in the
                                                          current period.
                                                          7. The summarization of recorded
                                                          transactions should not be understated.
                                                          8. All accounts that belong in the financial
                                                          statements should be so included. There
                                                          should be no undisclosed assets or liabilities.
Valuation or
Allocation
Transaction-Related

Accuracy:
9. Transactions are recorded at
incorrect amounts.

Line Item/Account-Related

Valuation:
10. Assets and liabilities included in the
financial statements are valued on an
inappropriate basis.

Measurement:
11. Revenues and expenses included
in the financial statements are
measured improperly.
9. Transactions should be recorded at correct
amounts.
                                                          10. Assets and liabilities included in the
                                                          financial statements should be valued on an
                                                          appropriate valuation basis.
                                                          11. Revenues and expenses included in the
                                                          financial statements should be properly
                                                          measured.
                                         Appendix D-Page 3

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 ASSERTION
            POTENTIAL
         MISSTATEMENT
         CONTROL OBJECTIVE
 Rights and
 Obligations
Line Item/Account-Related

Ownership:
12. Recorded assets are owned by
others because of sale, consignment,
or other contractual arrangements.

Rights:
13. The entity does not have certain
rights to recorded assets because of
liens, pledges, or other restrictions.

Obligations:
14. The entity does not have an
obligation for recorded liabilities at a
given date.
12. Recorded assets should be owned by the
entity.
                                                             13. Assets should be the entity's rights at a
                                                             given date.
                                                             14. Liabilities should be the entity's obligations
                                                             at a given date.
 Presentation
 and Disclosure
Line Item/Account-Related

Account Classification:
15. Accounts are not properly classified
and described in the financial
statements.

Consistency:
16. The financial statement
components are based on accounting
principles different from those used in
prior periods.

Disclosure:
17. Required information is not
disclosed in the financial statements or
in the footnotes thereto.
15. Accounts should be properly
classified and described in the
financial statements.
                                                             16. The financial statement components
                                                             should be based on accounting principles that
                                                             are applied consistently from period to period.
                                                             17. The financial statements or footnotes
                                                             thereto should contain all information required
                                                             to be disclosed
 See Note Below
Transaction-Related

Segregation of Duties:
18. The entity is exposed to loss of
assets and various potential
misstatements, including certain of
those above, as the result of
inadequate segregation of duties.
                                                             18. Persons should be prevented from having
                                                             uncontrolled access to both assets and
                                                             records.
Note: Segregation-of-duties controls are a type of safeguarding control and are often crucial to the effectiveness of
controls, particularly over liquid or readily marketable assets that are highly susceptible to theft,  loss, or
misappropriation. Such controls are designed to reduce the opportunities for any person to be in a position to both
perpetrate and conceal errors or irregularities. The lack of segregation-of-duties controls may be pervasive and
affect several misstatements.
                                            Appendix D-Page 4

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Appendix E
Sample Representation Letter

(On auditee letterhead)

                                                                          [Date of Audit Report]

To

In connection with your audit of the balance sheet and the related statements of revenues, expenses and
changes in fund balance, and cash flows of the State of XXXXXX  Revolving Fund, as of [balance sheet
date], for the year then ended, for the purpose of expressing an opinion as to whether the financial
statements present fairly, in all material respects, the financial position, results of operations, and cash
flows of the State of XXXXXX Revolving Fund in conformity with generally accepted accounting principles,
we confirm, to the best of our knowledge and belief, the following representations made to you during your
audit.

        1.  We are responsible for the fair presentation in the financial statements of financial position,
           results of operations, and cash flows in conformity with generally accepted accounting
           principles.

        2.  We have made available to you all -
           a.      Financial records and related data.
           b.      Minutes of the meetings of the [Governing Board] of the State Revolving Fund.

        3.  There have been no -
           a.      Irregularities involving management or employees who have significant roles in the
                   internal control structure.
           b.      Irregularities involving other employees that could have a material effect on the
                   financial statements.
           c.       Communications from regulatory agencies concerning noncompliance with, or
                   deficiencies in, financial reporting practices that could have a material effect on the
                   financial statements.

        4.  We have no plans or intentions that may materially affect the carrying value or classification of
           assets and liabilities.

        5.  There are no related party transactions or related amounts receivable with the State of
           XXXXXX Revolving Fund management or the [Governing Board] members.

        6.  Arrangements with financial institutions involving compensating balances or other
           arrangements involving restrictions on cash balances have been properly disclosed in the
           financial statements.

        7.  There are no -
           a.      Violations or possible violations of laws or regulations whose effects should be
                   considered for disclosure in the financial statements  or as a basis for recording a
                   loss contingency.
           b.      Other material liabilities or gain or loss contingencies that are required to be accrued
                   or disclosed by Statement of Financial Accounting Standards No.5.
                                        Appendix E-Page 1

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       8.  There are no unasserted claims or assessments that our counsel has advised us are
           probable of assertion and must be disclosed in accordance with Statement of Financial
           Accounting Standards No. 5.

       9.  There are no material transactions that have not been properly recorded in the accounting
           records underlying the financial statements.

       10. We have complied with all aspects of contractual agreements that would have a material
           effect on the financial statements in the event of noncompliance.

       11. No events have occurred subsequent to the balance sheet date that would require adjustment
           to, or disclosure in, the financial statements.
Signatures

Chief Executive Officer


Chief Financial Officer
                                        Appendix E-Page 2

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Appendix F

Sample Financial Statements
Note: The following financial statements are intended to be as guides for reporting SRF operations. The
format of these examples do not encompass all possible reporting needs for every state. Considerable
judgment in presentation is required.

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AppGndJX F-1: Direct loan program, without administrative fund.
                       Sample State
         Water Pollution Control Revolving Fund
                   Financial Statements with
                 Independent Auditor's Report

                          June 30, 2XXX
                         Appendix F-1, Page 1

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                                        Sample State
                           Water Pollution Control Revolving Fund

                                      Table of Contents
Independent Auditor's Report	  1

Balance Sheet 	  2

Statement of Revenues, Expenses and Changes in Net Assets	  3

Statement of Cash Flows	  4

Notes to the Financial Statements	  5

Independent Auditor's Report on the Internal Control Structure Based on an
       Audit of the Financial Statements Performed In Accordance with
       Government Auditing Standards	  12

Independent Auditor's Report on Compliance with the Requirements Applicable to the Environmental
       Protection Agency's State Revolving Fund Program  in Accordance with
        Government Auditing Standards  	  15
                                      Appendix F-1, Page 2

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                                Independent Auditor's Report

Sample State Water Pollution Control Board

We have examined the accompanying balance sheet of the Sample State Water Pollution Control
Revolving Fund as of June 30, 2XXX, and the related statements of revenues, expenses and changes in
net assets, and cash flows for the year then ended.  These financial statements are the responsibility of
the Fund's management.  Our responsibility is to express an opinion on these financial statements based
on our audit.

We conducted our audit in accordance with auditing standards generally accepted in the United States of
America and standards applicable to financial audits contained in Government Auditing Standards, issued
by the Comptroller General of the United States. Those standards require that we plan and perform the
audit to obtain reasonable assurance about whether the financial statements are free of material
misstatement. An audit includes examining, on a test basis, evidence supporting  the amounts and
disclosures in the financial statements.  An audit also includes assessing the accounting principles used
and significant estimates made by management, as well  as evaluating the overall financial statement
presentation.  We  believe that our audit provides a reasonable basis for our opinion.

Except as discussed in the following paragraph, we conducted our audit in accordance with generally
accepted auditing  standards and Government Auditing Standards issued by the Comptroller General of
the United States.  Those standards require that we plan and perform the audit to obtain reasonable
assurance about whether the financial statements are free  of material misstatement.  An audit includes
examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements.
An audit also  includes assessing the accounting principles  used  and significant estimates made by
management, as well as evaluating the  overall financial statement presentation.  We believe that our audit
provides a reasonable basis  for our opinion.

The scope of our audit did not include an audit of the financial statements of the preceding year sufficient
to enable us to express, and we do not express, an opinion on the balance sheet  of the Fund as of June
30, 2000 or the related statements of revenue, expenses and changes in fund balance, and cash flows for
the year then  ended, nor do we express an opinion on the consistency of application of accounting
principles with the  preceding year.

In our opinion, the financial statements referred to in the first paragraph present fairly,  in all material
respects, the financial position of the Sample State Water Pollution Control Revolving  Fund as of June 30,
2XXX and the results of its operation and its cash flows for the year then ended in conformity with
generally accepted accounting principles.

As discussed in Note 1, the financial statements referred to above are intended to present the financial
position and results of operations of the Sample State Water Pollution Control Revolving Fund, a
component of the Sample State.  These statements are not intended to present the financial position or
results of operations for the Sample State or the State Department of the Environmental Protection, of
which the Sample  State Water Pollution Control Revolving  Fund  is a part.

In accordance with Government Auditing Standards, we have also  issued a  report dated September 15,
2XXX, on  our consideration of the Sample State Water Pollution  Control Revolving Fund's internal control
structure and  a report dated  September 15, 2XXX on its compliance with laws and regulations.


Firm Name
Location
September 15, 2XXX


                                       Appendix F-1, Page 3

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          Assets
                                        Sample State
                      WATER POLLUTION CONTROL REVOLVING FUND

                                        Balance Sheet
                                        June 30, 2XXX
                         With Unaudited Comparative Totals for 2XXY
                                        (in thousands)
2XXX
Current Assets:
 Cash and cash equivalents
 Receivables:
   Interest on loans
   Interest on investments
   Other
   Total receivables
   Current maturities of loans receivable
Total current assets

Loans receivable, net of origination fees and current maturities

 Total assets

  Liabilities and Net Assets	

Current liabilities:
 Accounts payable and accrued expenses
 Construction costs payable
 Other
Total current liabilities

Net assets

Total liabilities and net assets
$  101,082

     2,693
     1,254
     1,206
     5,153
    16,238
   122,473

   410,834
   532,589
Unaudited
   2XXY
   $  67,701

       2,284
         997
       3,364
       6,645
      14,378
      88,724
& 184
516
18
718
$



222
4,414
30
4,666
     429,089
               The accompanying notes are an integral part of the financial statements.
                                       Appendix F-1, Page 4

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                                      Sample State
                     WATER POLLUTION CONTROL REVOLVING FUND

                Statement of Revenues, Expenses and Changes in Net Assets
                             For the year ended June 30, 2XXX
                        With Unaudited Comparative Totals for 2XXY
                                      (in thousands)
Revenues:
 Interest on loans
 Investment income

 Total revenues

Expenses:
 Administrative expenses

Operating income

Non-operating income:
 EPA capitalization grant
 Sample State contribution

Change in net assets

Net assets, beginning of year

Net assets, end of year
                                                               2XXX
 11,943
  4,513
 16,456
  2,664
 13,792

 81,707
  8,001

103,500
429,089
           Unaudited
             2XXY
  8,423
  2,951
 11,374
  2,637
  8,737


 73,686
 22,148

104,571

325,238
              The accompanying notes are an integral part of the financial statements.
                                     Appendix F-1, Page 5

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                                        Sample State
                      WATER POLLUTION CONTROL REVOLVING FUND
                                   Statement of Cash Flows
                               For the year ended June 30, 2XXX
                         With Unaudited Comparative Totals for 2XXY
                                        (in thousands)
Cash flows from operating activities:
  Operating income

Adjustments to reconcile operating income to
 net cash flow provided by operating activities:
  Amortization of loan fees
  Changes in  assets and liabilities:
   (Increase) Decrease in receivables
    Increase (Decrease) in accounts payable and
     accrued expenses

Net cash provided by operating activities

Cash flows from noncapital and related financing activities:
  Funds received from Environmental Protection Agency
  Funds received from the Sample State
  Contribution of state matching funds from local agencies

Net cash provided by noncapital and  related financing activities

Cash flows from investing activities:
  Loan disbursements
  Repayments on loans receivables

Net cash used in investing activities

Increase in cash and cash equivalents

Cash and cash equivalents, beginning of year

Cash and cash equivalents, end of year
                                                                  2XXX
$    13,792
               Unaudited
                  2XXY
$    8,737
(48)
1,492
(3,948)
1 1 ,288
81,707
8,001
1,584
91,292
(83,577)
14,378
(69,199)
33,381
67,701

(3,975)
(30)
4,732
73,686
22,148
95,834
(87,218)
11,116
(76,102)
24,464
43,237
               The accompanying notes are an integral part of the financial statements.
                                       Appendix F-1, Page 6

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                                        Sample State
                      WATER POLLUTION CONTROL REVOLVING FUND
                               Notes to Financial Statements
                                       June 30, 2XXX
                                        (in thousands)

1.      Organization of the Fund

       The Sample State Water Pollution Control Revolving Fund (the Fund) was established pursuant to
       Title VI of the  Federal Water Quality Act of 1987 (the Act).  The Act established the state
       revolving fund (SRF) program to replace the construction grants program to provide loans at
       reduced interest rates to finance the construction of publicly owned water pollution control
       facilities,  nonpoint source pollution control projects, and estuary management plans. Instead of
       making grants to communities that pay for a portion of building wastewater treatment facilities, the
       SRF provides for low interest rate loans to finance the entire cost of qualified projects.  The SRF
       provides  a flexible financing source that can be used for a variety of pollution control projects,
       including non-point source pollution control projects, and developing estuary conservation and
       management  plans.  Loans made by the Fund must be repaid within 20 years, and all
       repayments, including interest and principal, must remain in the  Fund.

       The Fund was capitalized by the U.S. Environmental Protection Agency (EPA) by a series of
       grants starting in 1989. States are required to provide an additional 20 percent of the Federal
       capitalization grant as matching funds in order to receive a grant.  As of June  30, 2XXX, Congress
       authorized the EPA to award $627,041 in capitalization grants to Sample State (the State). The
       State is required to contribute $125,408 in matching funds.

       The Fund is administered by the Sample State Department of Environmental Protection (SDEP)
       through the Division of Clean Water Programs of the State Water Resources Control Board (the
       Board).  SDEP's primary activities with regard to the SRF include the making of loans for water
       pollution  control facilities, and the management and coordination of the Fund. The Board consists
       of five members, all of which are appointed by the Governor.

       The Fund does not have any full time employees. Instead, SDEP charges the Fund for time spent
       on SRF activities by employees of the Board, and the Fund reimburses the State General Fund
       for such costs in the following month. The charges include the salaries and benefits of the
       employees, as well as indirect costs allocated to the Fund based on direct salary costs.
       Employees charging time to the Fund are covered by the benefits  of the State. The Fund  is also
       charged indirect costs of the State through the cost allocation plan for general state expenses.

       The Fund is included in the State's general purpose financial statements as a Special Revenue
       Fund  using the modified accrual basis.  Because of the different presentation, there may be
       differences between the amounts reported in these financial statements and the general purpose
       financial statements.
2.      Summary of Significant Accounting Policies

       Basis of Accounting

       The Fund presents its financial statements as an proprietary (enterprise) fund. The Fund uses the
       accrual method of accounting whereby revenues are recorded as earned and expenses are
       recorded when the liability is incurred. The State has elected to follow the accounting
       pronouncements of the Governmental Accounting Standards Board (GASB), as well as
       statements issued by the Financial Accounting Standards Board before November 30, 1989
       unless the pronouncements conflict with or contradict GASB pronouncements.
                                       Appendix F-1, Page 7

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                                        Sample State
                      WATER POLLUTION CONTROL REVOLVING FUND
                               Notes to Financial Statements
                                       June 30, 2XXX
                                        (in thousands)

2.      Summary of Significant Accounting Policies (continued)

       Cash and Cash Equivalents

       All moneys of the Fund are deposited with the State Treasurer's Office, and are considered cash.
       According to State law, the Treasurer is responsible for maintaining the cash balances and
       investing excess cash of the Fund, as discussed in Note 3.  Therefore, management of the  Fund
       does not have any control over the investment of excess cash, and the statement of cash flows
       considers all funds deposited with the Treasurer to be cash or cash equivalents, regardless of
       actual maturities of the underlying investments.

       Loans Receivable

       The State operates the Fund as a direct loan program, whereby loans made to communities are
       83.3 percent funded by the Federal capitalization grant, and 16.7 percent by the state matching
       amount.  Loan funds are disbursed to the local agencies as they expend funds for the purposes of
       the loan, and request reimbursement from the Fund. Interest is calculated from the date that
       funds are advanced, and after the final disbursement has been made, the payment schedule
       identified in the loan agreement is adjusted for the actual amounts disbursed, and interest
       accrued during the project period. No provision for uncollectible accounts has been made as all
       loans are current, and management believes that all loans will be repaid according to the  loan
       terms.

       Capitalization Grants

       In accordance with generally accepted  accounting principles, funds  received from the EPA and
       the State for the capitalization of the Fund are recorded as non-operating revenues.  In certain
       cases, local communities have contributed the State's 20 percent match in exchange for zero
       interest rate  loans. The state match made by local agencies has been recorded as a reduction in
       the loan receivable, and amortized to interest income over the life of the  loan in accordance with
       the provisions of Financial Accounting Standards Board Statement No. 91, Accounting for
       Nonrefundable Fees and Costs Associated with Originating or Acquiring Loans and Initial Direct
       Costs of Leases, as further discussed in Notes 4 and 5.

       Budget Information

       Under the Sample State constitution, money may only be drawn from the Treasury by a legal
       appropriation. However, the Fund operates under a continuous appropriation because the
       funding of the matching funds approved by the voters contained  its own appropriation authority.
       Therefore, the Fund operations are not included in the State's annual budget.

       Reclassifications

       Certain amounts in the 2XXY unaudited financial statements have been  reclassified to conform to
       the presentation in the 2XXX financial statements.
                                       Appendix F-1, Page 8

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                                        Sample State
                      WATER POLLUTION CONTROL REVOLVING FUND
                               Notes to Financial Statements
                                       June 30, 2XXX
                                        (in thousands)

3.      Cash and cash equivalents

       All monies of the Fund are deposited with the Treasurer, and are considered to be cash. The
       Treasurer is responsible for maintaining the cash balances in accordance with State laws, and
       excess cash is invested in the State's Surplus Money Investment Fund (SMIF), which is part of
       the Pooled Money Investment Account (PMIA). Details of the investments of the PMIA can be
       obtained from the State Treasurer. As of June 30, 2XXX, the latest date available, the State's
       total pooled investments were approximately $26 billion, and the average remaining  life of the
       securities invested was 291 days. The combined deposits of the SMIF as of June 30, 2XXX was
       approximately $12.1 billion, and total earnings for the year ended June 30, 2XXX were
       approximately $662 million.

       All cash of the Fund is stated at cost. Investments in local government investment pools are not
       categorized because they are not evidenced by securities that exist in physical or book entry form.
       Details of invested funds at June 30, 2XXX are:

                                                         Carrying         Market
                                                         Amount          Value
          Not subject to categorization:
            Local government investment pool
4.      Loans Receivable

       The Fund makes loans to qualified agencies for projects that meet the eligibility requirements of
       the Act.  Loans are financed by capitalization grants, state match, local contributions, and
       revolving funds. Effective interest rates on loans vary between 1.8 percent and 4.0 percent, and
       are generally repaid over 20 years starting one year after the project is completed.  Details of
       loans receivable as of June 30, 2XXX are:

       Loans by Category:

       Loans receivable at June 30, 2XXX, net of loan origination fees, as discussed below, are as
       follows:

                                        Loan           Remaining
                                      Authorized      Commitment        Balance
          Completed projects           $ 280,423        $         0     $   224,290
          Projects in progress             298,204            94,059         202,782

            Totals                     $ 578,627        $   94,059         427,072

          Less amount due within one year                                    16,238

          Loans receivable, net, June 30, 2XXX                          $   410,834

       Loans mature at various intervals through June 30, 2016.  The scheduled principle payments on
       loans maturing in subsequent years are as follows:
                                       Appendix F-1, Page 9

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                                        Sample State
                      WATER POLLUTION CONTROL REVOLVING FUND
                               Notes to Financial Statements
                                       June 30, 2XXX
                                        (in thousands)
4.      Loans Receivable (continued)

       Year ending June 30:

              1998
              1999
              2000
              2001
              2002
              Thereafter
Amount

   16,238
   22,199
   25,082
   27,442
   28,270
 307,841
       Loan Origination Fees:

       Beginning in 2XXX, the Fund offered local agencies the option of receiving zero-interest rate loans
       (zero-rate loans).  In order to obtain a zero-rate loan, the agency had to pay The State's matching
       share of the loan, generally 16.7 percent of the total loan amount. EPA considers the amounts
       paid by local agencies as meeting The State's matching requirement.  However, Financial
       Accounting Standards Board Statement No. 91, Accounting for Nonrefundable Fees and Costs
       Associated with Originating or Acquiring Loans and Direct Initial Costs of Leases (FASB No. 91),
       states that fees that reduce the loan's interest rate are considered origination fees, and requires
       that loan  origination fees be deferred and recognized over the life of the loan  as an adjustment to
       the interest rate.  FASB 91 also requires that the unamortized balance of such fees be reported as
       part of the loan to which it relates.

       As of June 30, 2XXX, seven agencies entered into agreements for zero-rate loans for $16,271,
       which includes total matching funds of $2,712 to be contributed by the local agencies.  At the
       balance sheet date, the local agencies had provided $1,584 in matching funds on loans disbursed
       as of that date. Details of the loans are:
Loan
Amount
Authorized
$ 3,869
12,402
Funds
Disbursed
$ 3,869
4,956
Unamortized
Loan
Origination
Fee
$ 595
941
Loan
Balance
$ 3,274
4,015
       Completed projects
       Projects in progress

         Totals
       Amortization of loan origination fees on completed projects was $48 for the year ended June 30,
       2XXX.

       Loans to Major Local Agencies

       As of June 30, 2XXX, the Fund had made loans to eleven agencies that, in the aggregate,
       exceeded $10 million. The outstanding balances of these loans represents approximately 81
       percent of the total loans receivable, as follows:
                                      Appendix F-1, Page 10

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                                 Sample State
               WATER POLLUTION CONTROL REVOLVING FUND
                        Notes to Financial Statements
                                June 30, 2XXX
                                 (in thousands)
Loans Receivable (continued)
	Local Agency	

City & County of San Angelo
Los Pablo County
Western Utility District
Santana Water Authority
City of Bear River
Miller's Valley Sewer District
Union Valley Sanitation District
City of Independence
High Water Flood Control District
City of Gainesville
Moose Jaw Sanitary District

  Total
 Authorized
Loan Amount
                 Outstanding
                   Balance
  $
136,316
 63,711
 60,360
 43,933
 29,007
 18,736
 18,000
 15,991
 12,142
 11,675
 11,305
$
108,469
 52,090
 51,932
 42,087
 21,094
 15,856
 16,376
 13,422
  9,862
  7,624
  8,191
The authorized loan amount includes both completed projects and projects in progress. As of
June 30, 2XXX, principal repayments on completed projects to the above agencies was $42,826
and remaining amounts to be disbursed on projects in progress was $30,774.
Fund Equity

The Fund is capitalized by grants from EPA authorized by Title VI of the Act, matching funds from
the State, and contributions by certain local agencies.  All funds drawn are recorded as non-
operating revenues from the Environmental Protection Agency and Sample State.  As of June 30,
2XXX, EPA has awarded capitalization grants of $627,041 to the State, of which $404,408 has
been drawn for loans and administrative expenses. The State has provided matching funds of
$91,947.  The following summarizes the capitalization grant awarded, amounts drawn on each
grant as of the balance sheet date, and balances available for future loans:


Year Grant
Pre1994 $
1995
1996
1997
1998
1999
1999
2XXY
2XXX


Amount
76,547
71,866
88,067
83,377
82,479
51,177
52,855
86,578
34,095
Total Draws
June 30,
2XXY
$ 76,496
69,501
82,706
64,930
27,675
1,393
0
0
0


2XXX Draws
$ 18
945
3,901
15,970
23,393
25,299
7,181
5,000
0
Total Draws
June 30,
2XXX
$ 76,514
70,446
86,607
80,900
51,068
26,692
7,181
5,000
0
Available
June 30,
2XXX
$ 33
1,420
1,460
2,477
31,411
24,485
45,674
81,578
34,095
Totals
                               Appendix F-1, Page 11

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5.      Fund Equity (continued)

       As of June 30, 2XXY and 2XXX, State matching contributions were:

                                 June 30,        2XXX             June 30,
                                  2XXY        Contribution           2XXX

       Sample State             $    83,946      $   8,001      $    91,947

       As discussed in Note 4, certain local agencies provided the State's 20 percent match in exchange
       for zero interest loans.  As of June 30, 2XXX, the amount contributed by local agencies was
       $1,584. The EPA considers the local agency contributions as part of the  State's 20 percent
       matching funds.  However, according to generally accepted accounting principles, the amounts
       are not included as part of the State's contributed capital in these financial statements.


6.      Contingencies and  Subsequent Events

       Contingencies

       The Fund is exposed to various risks of loss related to torts, thefts of assets, errors or omissions,
       injuries to state employees while performing Fund business, or acts of God.

       The Fund maintains insurance for all risks of loss which is included in the indirect costs charged to
       the Fund. There have  not been any claims against the Fund since its inception in 1989.

       Subsequent events

       Subsequent to year end, the EPA awarded the 1998 capitalization grant to the State. The grant
       provides $53,489 in additional funds,  including the State matching share of $8,915, for making
       loans to qualified communities.
                                      Appendix F-1, Page 12

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 Independent Auditor's Report on the
Internal Control Structure Based on an
  Audit of the Financial Statements
    Performed In Accordance with
   Government Auditing Standards
            Appendix F-1, Page 13

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Sample State Water Pollution Control Revolving Fund

We have audited the financial statements of the State Water Pollution Control Revolving Fund as of and
for the year ended June 30, 2XXX, and have issued our report thereon dated September 15, 2XXX.

We conducted our audit in accordance with generally accepted auditing standards and Government
Auditing Standards issued by the Comptroller General of the United States. Those standards require that
we plan and perform the audit to obtain reasonable assurance about whether the financial statements are
free of material misstatement.

The management of the State Water Pollution Control Revolving Fund is responsible for establishing and
maintaining an internal control structure. In fulfilling this responsibility, estimates and judgements by
management are required to assess the expected benefits and related costs of internal control policies
and procedures.  The objectives of an internal control structure are to  provide management with
reasonable, but not absolute, assurance that assets are safeguarded against loss from unauthorized use
or disposition and that transactions are executed in accordance with management's authorization and
recorded properly to permit the preparation of financial statements in accordance with generally accepted
accounting principles.  Because of inherent limitations in any internal control structure, errors or
irregularities may nevertheless  occur and not be detected. Also, projection of any evaluation of the
structure to future periods is subject to the risk that procedures may become inadequate because of
changes in conditions or that the effectiveness of the design and operation of policies and procedures may
deteriorate.

In planning and performing our audit of the financial statements of the State Water Pollution Control
Revolving Fund for the year ended June 30, 2XXX, we obtained an understanding of the internal control
structure. With respect to the internal control  structure, we obtained an understanding of the design of
relevant policies and procedures and whether they have been placed in operation, and we assessed
control risk in order to determine our auditing procedures for the purpose of expressing our opinion on the
financial statements and  not to  provide an  opinion on the internal control structure. Accordingly, we do not
express such an opinion.

Our consideration of the internal control structure would not  necessarily disclose all matters in the internal
control structure that might be material weaknesses under standards established by the American Institute
of Certified Public Accountants. A material weakness is a condition in which the design  or operation of
one or more of the specific internal control elements does not reduce to a relatively low level the risk that
errors and irregularities in amounts that would be material in relation to the financial statements being
audited  may occur and not be detected within a timely period by employees in the normal course of
performing their assigned functions. We noted no matters involving the internal control structure and its
operations that we consider to be material weaknesses as defined above.

This report is intended for the information of management of the State Water Pollution Control Revolving
Fund and the United States Environmental Protection Agency. However, this report is a matter of public
record and distribution is not limited.
Firm
City

September 15, 2XXX
                                        Appendix F-1, Page 14

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            Independent Auditor's Report
on Compliance with the Requirements Applicable to the
         Environmental Protection Agency's
           State Revolving Fund Program
                in Accordance with
           Government Auditing Standards
                   Appendix F-1, Page 15

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Sample State Water Pollution Control Revolving Fund

We have audited the financial statements of the Sample State Water Pollution Control Revolving Fund
(the Fund) as of and for the year ended June 30, 2XXX, and have issued our report thereon dated
September 15, 2XXX

We have also audited the Fund's compliance with requirements governing:

        Allow/ability for Specific Activities;
        Allowable Costs/Cost Principles;
        Cash Management;
        State Matching;
        Period of Availability of Funds and Binding Commitments;
        Program Income;
        Reporting;
        Subrecipient Monitoring, and;
        Special tests and provisions;

that are applicable to its major Federal financial assistance program for the year ended June 30, 2XXX.
The management of the State Water Pollution Control Revolving Fund is responsible for the Fund's
compliance with those requirements. Our responsibility is to express an opinion on those requirements
based on our audit.

We conducted our audit of compliance with those requirements in accordance with generally accepted
auditing standards, Government Auditing Standards, issued by the Comptroller General of the United
States, and the Environmental Protection Agency State Revolving Fund Audit Guide. Those standards
require that we plan and perform the audit to obtain reasonable assurance about whether material
noncompliance with the requirements referred to above occurred. An audit includes examining, on a test
basis, evidence about the Fund's compliance with those requirements. We believe that our audit provides
a reasonable basis for our opinion.

In our opinion, the State Water Pollution Control Revolving Fund complied,  in all material respects, with
the requirements governing types of service and types of costs allowed or unallowed; matching, level of
effort or earmarking requirements; special reporting requirements; special tests and provisions; and
claims for advances and reimbursements that are applicable to its major Federal financial assistance
program for the year ended June 30, 2XXX.

This report  is intended for the information of management of the Fund and the United States
Environmental Protection Agency. However, this report is a matter of public record and its distribution is
not limited.
Firm
City

September 15, 2XXX
                                       Appendix F-1, Page 16

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AppGndJX F-2:     Direct loan program with administrative fee fund.
                                         Sample State
                       WATER POLLUTION CONTROL REVOLVING FUND
                                   Combining Balance Sheet
                                         June 30, 2XXX
                          With Unaudited Comparative  Totals for 2XXY
                                         (in thousands)

                                                          2XXX
              Assets
Current Assets:
 Cash and cash equivalents
 Receivables:
   Interest on loans
   Interest on investments
   Other
   Total receivables
   Current maturities of loans receivable
Total current assets

Loans receivable, net

 Total assets

       Liabilities and Net Assets	

Current liabilities:
 Accounts payable and accrued expenses
 Construction costs payable
 Other
Total current liabilities

Net assets

Total liabilities and net assets
Loan Fund    Administration
  $  101,082

      2,693
      1,254
      1,206
      5,153
      16,238
     122,473

     410,834

     533,307
        184
        516
   	18
        718

    532,589

  $ 533,307
$   6,010
    6,010
    6,010
       73
       73
    5,937
               Total
$   6,010
$  107,092

     2,693
     1,254
     1,206
     5,153
    16,238
   128,483

   410,834

   539,317
      257
      516
 	18
      791

   538,526

$  539,317
               2XXY
            (Unaudited)
$  72,866

    2,284
      997
    3,364
    6,645
   14,378
   93,889
  345,031

 $438,920
      272
    4,414
   	30
 $438,920
                                        Appendix F-2, Page 1

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                      WATER

         Combining Statement

                         With
          Sample State
POLLUTION CONTROL REVOLVING FUND

of Revenues, Expenses and Changes in Fund Net Assets
For the year ended June 30, 2XXX
Unaudited Comparative Totals for 2XXY
          (in thousands)
Revenues:
 Interest on loans
 Investment income
 Loan fees
 Total revenues

Expenses:
 Salaries and benefits
 Other expenses
Total operating expenses

Operating income

Non-operating income:
 EPA capitalization grant
 Sample State contribution

Change in fund equity

Net assets, beginning of year

Net assets, end of year
                                                        2XXX
                                       Loan Fund    Administration
                                        Total
               11,943
               4,513
               16,456
1,578
 328
1,906
11,943
 6,091
  328
18,362
                        2XXY
                     (Unaudited)
 8,423
 4,294
  258
12,975
2,630
34
2,664
13,792
81,707
8,001
103,500
429,089
992
19
1,011
895
895
5,115
3,695
53
3,748
14,614
81,707
8,001
104,322
434,204
3,342
69
3,411
9,654
73,686
22,148
105,398
328,806
                                       Appendix F-2, Page 2

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                                           Sample State
                        WATER POLLUTION CONTROL REVOLVING FUND

                               Combined Statement of Cash Flows
                                 For the year ended June 30, 2XXX
                           With Unaudited Comparative Totals for 2XXY
                                           (in thousands)
Cash flows from operating activities:
  Cash received from customers
  Cash payments to borrowers
  Cash payments to employees and suppliers
  Interest received on investments
  Other

 Net cash used by operating activities

Cash flows from noncapital and related financing activities:
  Funds received from EPA
  Funds received from the Sample State

Net cash provided by noncapital and related financing activities

Increase in cash and cash equivalents

Cash and cash equivalents, beginning of year

Cash and cash equivalents, end of year

Cash flows from operating activities:
  Operating income
Adjustments to reconcile operating income to net cash flow provided by
operations:
  Changes in assets and liabilities:
 (Increase) decrease in accounts receivable
  Increase (decrease) in accounts payable and accrued expenses
  Deferred income recognized
  Loan disbursements
  Loan principal repayments

 Net cash used by operating activities
                                                                     2XXX
$    26,949
    (79,679)
     (3,713)
      5,834
     (6,157)

    (57,066)
     81,707
      8,001

     91,292

     34,226

     72,866
$    14,614
                   2XXY
                (Unaudited)
$   19,057
    (79,804)
    (3,363)
     4,112
    (15,723)

    (75,721)
    73,686
    22,148

     95,834

    20,113

    52,753
$    8,737
(368)
(3,925)
(48)
(81,717)
14,378
(3,975)
(30)
(92,396)
11,116
 $  (57,066)
$   (75,721)
                                         Appendix F-2, Page 3

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AppGndJX F-3:     Direct loan program, state match provided by SRF revenue
                          bonds.

                                        Sample State
                              Clean Water State Revolving Fund
                                        Balance Sheet
                                   June 30, 2XXX and 2XXY
                                                             2XXX
                      2XXY
Cash and cash equivalents
Short-term investments
Current receivables:
 Loan interest
 Investment interest
 Current portion of loans receivable
Total current receivables

Loans receivable:
Issuance costs, net
 Loans receivable, net

Total assets

Liabilities and Equity:
Current liabilities:
Bond Interest Payable
Current Portion of Bonds Payable
Total current liabilities

Long-term Liabilities:
Bonds Payable
Unamortized premium (discount)

Total Liabilities

Net assets

Total liabilities and net assets
$  73,545,494
    4,344,075

     630,223
     236,233
    6,913,742
    7,780,198

  109,507,111
       42,322
  109,549,433

  195,219,200
       39,235
    2,300,000
    2,339,235
    2,045,000
	6,090

    4,390,325

  190,828,875

$195,219,200
 $ 62,737,151
    2,287,710

     733,154
      46,141
   20,442,282
    1,521,577

   95,242,454
      16,676
   95,259,130

  181,805,568
      23,040
    2,295,000
    2,318,040
    1,190,000
      (7.317)

    3,500,723

  178,304,845

$181,805,568
                                      Appendix F-3, Page 1

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                                       Sample State
                              Clean Water State Revolving Fund
                                      Income Statement
                         For the years ended June 30, 2XXX and 2XXY

                                                             2XXX
Operating revenues:
  Loan interest
  Investment income
  Other

 Total operating revenues

Operating expenses:
  Salaries and benefits
  Interest expense
  Amortization of bond issuance costs
  Indirect costs

  Total operating expenses

Operating income

Capital contributions-Federal grants

Change in net assets

Net assets, beginning of year

Net assets, end of year
 $ 2,419,031
   3,520,712
   5,939,743
   5,521,188

   7,002,842

  12,524,030

  178,304,845

$190,828,875
                     2XXY
 $ 2,219,654
   3,843,596
     151,331

   6,214,581
220,545
181,444
15,165
1,401
418,555
207,852
163,589
10,617
1,500
383,558
   5,831,023

   4,711,102

  10,542,125

 167,762,720

$178,304,845
                                      Appendix F-3, Page 2

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                                         Sample State
                               Clean Water State Revolving Fund
                                  Statements of Cash Flows
                         For the years ended June 30, 2XXX and 2XXY
                                                              2XXX
Cash flows from operating activities:
 Cash received from customers
 Cash payments to borrowers
 Cash payments to employees for services
 Other
 Interest on investments

Net cash (used) by operating activities

Cash flows from noncapital and related financing activities:
 Funds received from Environmental Protection Agency
 Purchase of investments
 Proceeds from revenue  bonds
 Principal  paid on  debt

Net cash provided  by noncapital and related financing activities

Increase in cash and cash equivalents

Cash and cash equivalents, beginning of year

Cash and cash equivalents, end of year
$ 35,320,945
 (33,535,100)
    (200,057)
    (183,358)
   3,630,620

   5,033,050
   7,002,842
  (2,056,365)
   4,304,168
  (3,475,352)

    5,775,293

   10,808,343

  62,737,151

  $73,545,494
     2XXY

$ 26,267,955
 (44,197,061)
    (211,812)
     (46,442)
   3,998,998

 (14,188,362)
   4,975,356
   (2,284,060)
   2,294,940
   (2,245,000)

   2,741,236

 (11,447,126)

  74,184,277

 $62,737,151
 Reconciliation of operating income to cash provided by operations:
  Revenues over expenses                                   $5,521,188
  Adjustments to reconcile operating income to net
   cash provided by operating activities:
  Amortization of bond issuance costs                              18,945
   (Increase) Decrease  in accounts receivable                    212,839
   Increase (Decrease) in accounts payable
        and accrued expenses                                    16,195
  Net increase in loans                                          (736,117)
                  $ 5,831,023
                       16,407
                      (86,723)

                      (26,054)
                  (19,923,015)
Net cash provided by operating activities
  $ 5,033,050     $(14,188,362)
                                       Appendix F-3, Page 3

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Appendix F-4:
Leveraged loan program.
                                      Sample State
                 WATER POLLUTION CONTROL REVOLVING FUND
                                       Balance Sheet
                                       June 30, 2XXX
           Assets
Current assets:
Cash and cash equivalents
Receivables:
  Interest receivable
  Due from Federal government
  Current portion of loans receivable
Total current assets

Restricted assets-cash and cash equivalents

Non-current assets:
  Loans receivable
  Equipment, net
  Other
Total non-current assets

Total assets

	Liabilities and Net Assets

Liabilities

Current liabilities:
  Accounts payable
  Due to other funds
  Bond interest
  Other
  Current portion of bonds payable
 Total current liabilities

Non-current liabilities-Bonds payable, net of discounts

 Total liabilities

Net assets:
  Invested in capital assets, net of debt
  Restricted for loans and debt service
  Unrestricted (deficit)

 Total

Total liabilities and  net assets
                                           $   5,848,935

                                                378,167
                                                803,931
                                               1,442,490
                                               8,473,523

                                               7,439,733
                                              32,728,067
                                                173,958
                                                 74,397
                                              32,976,422

                                              48,889,678
                                                345,299
                                                458,633
                                                 57,348
                                                120,443
                                               1,102,500
                                               2,084,223

                                               5,600,740

                                               7,684,963
                                                173,958
                                              41,151,200
                                                (120,443)

                                              41,204,715

                                            $48,889,678
                                      Appendix F-4, Page 1

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                                     Sample State
                 WATER POLLUTION CONTROL REVOLVING FUND
              Statement of Revenues, Expenses and Changes in Fund Net Assets
                                      June 30, 2XXX


Operating revenues:
  Loan interest                                                                   $   753,753
  Investment interest                                                                341,526
  Federal grants                                                                   3,565,526
Total operating revenues                                                            4,660,805

Operating expenses:
  Salaries and benefits                                                              1,429,653
  Professional services                                                              1,534,917
  Travel                                                                            70,926
  Office                                                                             40,125
  Equipment                                                                       237,563
  Depreciation and amortization                                                        121,919
  Interest expense                                                                   51,945
  Other                                                                            289,664
Total operating expenses                                                            3,776,712

Operating income                                                                   884,093

Non-operating revenue:
  Federal grant                                                                   20,007,098
  State contribution                                                                 3,571,346
Total non-operating revenue                                                       23,578,444

Increase in net assets                                                             24,462,537

Net assets, beginning of year                                                       16,742,178

Net assets, end of year                                                           $41,201,715
                                     Appendix F-4, Page 2

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                                       Sample State
                  WATER POLLUTION CONTROL REVOLVING FUND
                                   Statement of Cash Flows
                                        June 30, 2XXX


Cash flows from operating activities:
  Interest received on loans                                                         $    499,167
  Interest paid on bonds                                                                 (50855)
  Federal grant-administration                                                         3,402,975
  Payments to employees                                                            (1,392,206)
  Payments to suppliers                                                              (2,010,770)
  Investment income                                                                   241,527
Cash provided by operating activities                                                     789,838

Cash flows from noncapital financing activities:
  Federal grants                                                                    20,007,098
  State contributions                                                                 3,571,346
  Bonds issued                                                                      6,703,239
  Bond issuance costs                                                                 (74,397)
Net cash provided by noncapital financing activities                                      30,207,286

Cash flows from investing activities:
  Loans to governments                                                            (27,646,223)
  Principal repayments                                                               6,427,500
Net cash used in investing activities                                                   (21,218,723

Net increase in cash and  cash equivalents                                              9,778,401

Cash and cash equivalents, beginning of year                                           3,510,267

Cash and cash equivalents, end of year                                              $ 13,288,668

Reconciliation of net operating income to net cash provided by
   operating activities:
  Operating income                                                                $    884,093
  Adjustments to reconcile net operating income to net cash
   provided by operations:
  Depreciation and amortization                                                         121,919
  Changes in assets and  liabilities:
  (Increase) in current assets                                                          (417,137)
  Increase in current liabilities                                                           200,963
Net cash provide by operating activities                                               $  789,838
                                       Appendix F-4, Page 3

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AppGndJX F-5:        Drinking Water Statement of Revenues and Expenses, with
                           supplementary information on Set-Aside expenses.
                                     Sample State
                           Drinking Water State Revolving Fund
                  Statement of Revenue, Expense and Change in Net Assets
                            For the Year Ended June 30, 2XXX
Operating revenues:
 Interest on investments
 Interest on loans
 Administrative Fees
 EPA Set-aside Operating Grants

Total operating revenues

Operating Expenses
 Administration
 Technical Assistance
 Program Management
 Local Assistance
 Other
Total Operating Expenses

Operating income

Retained earnings, beginning of year

Retained earnings, end of year
Loan
Fund
$ 739,776
682,707
4,537,157
5,959,640
622,686
473,852
1,369,416
1,948,799
122,403
4,537,156
1,422,484
2,007,595
Loan Fee
Fund
$36,197
471,821
508,018


508,018
291,351
Total
$ 775,973
682,707
471,821
4,537,157
6,467,658
622,686
473,852
1,369,416
1,948,799
122,403
4,537,156
1,930,502
2,298,946
$ 3,430,079    $799,369   $4,229,448
                                    Appendix F-5, Page 1

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The following can be shown as supplemental information to provide additional information on the
details of Set-Aside expenses:
                                      Sample State
                            Drinking Water State Revolving Fund
                             Schedule of Set-Aside Expenses
                             For the Year Ended June 30, 2XXX
                                        State
                                      Program     Technical      Local
                     Administrative  Management   Assistance  Assistance      Total

Salaries and benefits      $  215,975   $   771,923    $ 176,080   $  494,540   $1,658,518
Equipment                                                         71,114       71,114
Contracts                   395,147       247,795       63,488     457,085    1,163,515
Travel                        5,749        17,359        5,740      16,125       44,973
Other expenses              117,536       325,281      235,657     920,562    1,599,036

Totals                   $  734,407   $ 1,362,358    $ 480,965  $1,959,426   $4,537,156
                                     Appendix F-5, Page 2

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