CHAPTER 3 GENERAL TYPES OF AUDIT

I. Review Questions 1. Financial statements audits, operational audits, and compliance audits are similar in that each type of audit involves accumulating and evaluating evidence about information to ascertain and report on the degree of correspondence between the information and established criteria. The differences between each type of audit are the information being examined and the criteria used to evaluate the information. An example of a financial statement audit would be the annual audit of AB !"B# "orporation, in which the external auditors examine AB !"B#$s financial statements to determine the degree of correspondence between those financial statements and generally accepted accounting principles. An example of an operational audit would be an internal auditor$s evaluation of whether the company$s computeri%ed payroll!processing system is operating efficiently and effectively. An example of a compliance audit would be a BI& auditor$s examination of an entity$s tax return to determine the degree of compliance with the #ational Internal &evenue "ode. &efer to pages () to (* of the textboo+. The text defines internal auditing as an independent appraisal activity in an entity. Internal auditing is itself a control that operates by examining and evaluating the ade,uacy and effectiveness of other controls. Independence is such an important aspect of internal auditing that the fourth section of the Statement of Responsibilities of Internal Auditing is devoted to independence. -rgani%ations create internal auditing to serve or benefit the organi%ation. The broad ob.ective of internal auditing is to provide assistance to members of the organi%ation to enable the members to meet their responsibilities effectively. Assistance may involve providing counsel or recommendations, analysis, or information. -ne goal of internal auditing should be to achieve effective control that is worth the cost. In describing the nature of internal auditing, the Statement of Responsibilities of Internal Auditing indicates that internal auditing functions by examining controls. The scope limits internal auditing$s responsibility for examining and evaluating performance to specific responsibilities that are assigned to individuals or units. Internal auditing examines and evaluates performance to compare the actual performance with plans, specified activities, standards,

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Solutions Manual - Principles of Auditing and Other Assurance Services

ob.ectives, policies, and goals. uch evaluations are really evaluations of controls because plans, specified activities, standards, ob.ectives, policies and goals are controls. Internal auditors may be called on to examine areas for which performance criteria have not been specified. /hen this occurs, internal auditors may select measurable criteria and report their findings in terms of those measurable criteria. For example, if internal auditors were called on to evaluate a credit department, they might present historical information as well as industry information to management as a basis for evaluating the credit department. (. Independence is the essence of auditing and enables auditors to render impartial and unbiased .udgments. The two conditions that contribute to an internal auditor$s independence are organi%ational status and auditor ob.ectivity. The internal auditors$ status must be such that they are respected throughout the organi%ation. 0enerally, the more respect management gives to the internal audit function, the greater the attention the whole organi%ation pays to their findings and recommendations. 0iving the highest!level person in internal auditing the status of vice president and having that person report to the board of directors$ audit committee give sufficient status to the internal audit function. -b.ectivity re,uires that internal auditors have an independent mental attitude and an honest belief in their wor+ product. "-A auditors perform operational or performance audits, compliance audits, and financial audits. An independent auditor is usually a "2A who has received a license to perform the attest function. To be a "2A, one generally must meet certain educational re,uirements and pass an examination. Internal auditors are employees of the organi%ation for which they do audits. They may perform financial auditing, compliance auditing, or operational auditing. They are not independent in the sense that external auditors are, although they may attain a degree of independence by their position in the organi%ation. Governmental auditors are employees of various government agencies who perform financial, compliance, and operational auditing. For example, local governments employ auditors to verify that businesses collect and remit sales tax as re,uired by law.

*. 1.

3.

Five specific examples of operational audits that could be conducted by an internal auditor in a manufacturing company are4 1. 5xamination of employee time cards and personnel records to determine if sufficient information is available to maximi%e the effective use of personnel.

General Types of Audit

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&eview the processing of sales invoices to determine if it could be done more efficiently. &eview the ac,uisitions of goods, including costs to determine if they are being purchased at the lowest possible cost considering the ,uality needed. &eview and evaluate the efficiency of the manufacturing process. &eview the processing of cash receipts to determine if they are deposited as ,uic+ly as possible.

There is always a chance something will slip by the auditor, even when the auditor does the best audit possible. Auditors focus on the areas where the ris+ of material errors and irregularities is greatest, which provides a high level of assurance that all material misstatements will be detected. 7owever, it does not provide a perfect guarantee that the audit will discover all material misstatements.

II. Multiple Choice Questions 1. '. ). (. *. 1. b c b b c d 3. 6. 8. 19. 11. 1'. c a a d b a 1). 1(. 1*. 11. 13. 16. d c d b c a 18. b '9. a '1. b

III. Comprehensive Cases Case 1. a. The conglomerate should either engage the management advisory services division of a "2A firm or its own internal auditors to conduct the operational audit. The auditors will encounter problems in establishing criteria for evaluating the actual ,uantitative events and in setting the scope to include all operations in which significant inefficiencies might exist. In writing the report, the auditors must choose proper wording to state that no financial audit was performed, that the procedures were limited in scope and that the results reported do not necessarily include all the inefficiencies that might exist. The shareholder is correct in observing that internal auditors are ,uite +nowledgeable about the company: and that the internal auditors could perform the audit at less cost than independent auditors. But the fact that they are not independent precludes the internal auditors from completing the annual audit. The independent auditor represents financial statement users, and adds ,uality to the financial statements prepared by management. The ,uality ingredients are application of expert +nowledge of accounting principles, and impartiality in conducting the examination.

b.

Case 2. a.

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Solutions Manual - Principles of Auditing and Other Assurance Services

;oreover, the ecurities and 5xchange Act of 18)( re,uires that financial statements of publicly held companies be examined by independent "2As. b. Independent auditing exists as a profession because the public has perceived a need for an impartial examination of financial statements issued by publicly held companies. ;anagement and stoc+holders are in an adversarial relationship to one another. ;anagement wishes to portray financial position, results of operations, and cash flows in the most favorable light. toc+holders re,uire financial statements which fairly present financial position, results of operations, and cash flows. 0iven this conflict of interest, independent auditing evolved to serve as an intermediary between management and stoc+holders and provide reasonable assurance that the published financial statements fairly represent management$s assertions. To maintain wide public acceptance of audited financial statements, "2As must be continually alert to any gap in public vs. professional perceptions regarding responsibility of the "2A. The "ode of 5thics for 2rofessional Accountants in the 2hilippines constitute an effort to narrow the gap and respond more fully to public expectations regarding the "2A$s role in providing professional services. The higher the level of reporting, the greater the authority possessed by the unit to which the report is directed. 0reater authority enhances the probability to prompt implementation of the auditor$s recommendations. To this end, many companies have their internal auditors report directly to the chief executive officer. ome companies assign responsibility for coordinating the system of internal control to the audit committee of the board of directors. The internal auditors, under these circumstances, may serve as liaison by reporting discovered control wea+nesses to the audit committee. <nder this type of arrangement, the audit committee typically has authority to re,uire timely correction of material wea+nesses.

Case 3. a.

b.

Case 4. a.

inancial auditing involves examining financial statements and attesting to the fairness of financial presentation: operational auditing relates to the study and evaluation of operating activities for the purpose of identifying inefficiencies and ma+ing recommendations for improvement: management auditing is an extension of operational auditing in that the auditor assesses management effectiveness in achieving entity goals, as well as evaluating operating efficiency. -perational auditing may be considered =input!oriented> while management auditing focuses on output. ;anagement audits are a ma.or function of the "ommission on Audit, which reports directly to "ongress concerning the efficiency and effectiveness of government agencies and other entities engaged in

b.

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business with the government. As an arm of "ongress, the "ommission on Audit has the authority to examine virtually any agency. These examinations typically assume the form of management audits whereby the auditors assess the efficiency and effectiveness with which the agency is being operated. "ongressional decisions concerning increasing or decreasing the level of funding, or even discontinuing a unit, are often based largely on the findings of the "-A. Case 5. a. -b.ectivity means that the internal auditor must have and maintain an unbiased and independent viewpoint in the performance of audit tests, evaluation of the results, and issuance of the audit findings. -b.ectivity would not exist if the internal auditor were to audit his or her own wor+. -b.ectivity implies that the internal auditor$s .udgment is not subordinate to the .udgment of another and that others do not exert an influence over the internal auditor. 1. -b.ectivity is not impaired. ?evelopment of written policies and procedures to guide @ee$s staff is a responsibility of the internal audit staff. The internal auditors are responsible for the independent evaluation and verification of a proper system of internal control. -b.ectivity is impaired. The preparation of ban+ reconciliations is a control over cash. To maintain ob.ectivity, the auditor should not perform assignments that are included as part of the independent evaluation and verification of proper internal control. eparation of duties should be maintained. -b.ectivity is not impaired in the review of the budget for reasonableness if the internal auditor has no responsibility for establishing or implementing the budget. 7owever, ob.ectivity is impaired when the internal auditor ma+es managerial decisions concerning performance in the review of variances. -b.ectivity is impaired in that the internal auditor will be called on to evaluate the design and implementation of the system in which he or she played a significant role. Testing of the internal controls would not impair ob.ectivity, because this activity is necessary for determining the ade,uacy of accounting and administrative controls. -b.ectivity is impaired. The internal auditors should not be involved in the recording process. Aes, the reporting relationship results in an ob.ectivity problem. The controller is responsible for the accounting system and related transactions. The internal audit staff is responsible for independent and ob.ective review and examination of the accounting system and related transactions. Independence and ob.ectivity may not exist

b.

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*. c. 1.

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Solutions Manual - Principles of Auditing and Other Assurance Services

because the internal audit staff is responsible for reviewing the wor+ of the corporate controller, the person to whom the staff reports. '. #o, the responses for b would not be affected by the internal audit staff$s reporting to an audit committee rather than the controller. To maintain ob.ectivity, the internal audit staff should refrain from performing nonaudit functions, such as management decision ma+ing, design and installation of systems, and record+eeping. Ideally, to avoid being called on to evaluate its own performance, the internal audit staff should perform only audit functions. This is true without regard to organi%ational reporting relationships.

d.

Dear President: We recommend that the manager of internal audit report to the vice president rather than the controller. A large part of the work of the internal auditors do involves an examination of the accounting system and related transactions which are functions for which the controller is directly responsible. If the manager of internal audit reports to the controller the controller may prevent the internal auditors from looking at issues that need to be examined. !urther the internal audit manager may feel compelled to avoid being completely candid about matters under the supervision of the controller. We will be pleased to discuss these and any other issues with you at your convenience.

"incerely Case 6. 2ere% is ta+ing a very narrow view of the "2A$s role in the economy. The reserved, aloof attitude recommended by 2ere% was perhaps .ustified a half! century or more ago when the primary ob.ective of many audits was the discovery of errors, defalcations, and other forms of fraud. In the current era, the auditors$ role has changed from that of a =detective> to that of accounting experts whose breadth of experience in the audit of many companies enables them to offer clients constructive advice which leads to compliance with accounting principles, improved accounting methods, better financial administration, and more profitable operation. To fulfill this broader role of advisers as well as impartial reviewers, the auditors need the cooperation of client personnel at all levels. They need managers and employees to spea+ freely of their problems and to explain fully why certain operating methods are followed. The audit will be far more effective if client personnel are willing to identify problem areas. This +ind of two!way communication between the client and the auditors will be possible only if the client views the auditors as approachable, cordial individuals with a sincere interest in helping the client.

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The auditors can be independent and ob.ective without being cold and impersonal. They should never convey the impression that they regard the client$s employees as potential embe%%lers. #either should they ta+e over office e,uipment or accounting records in a manner that suggests lac+ of consideration for the convenience and status of the client$s staff. The development of social relationships with the client outside the office, as advocated by Ferrer, is helpful to the "2A partner as it is to the architect, the physician, the attorney, and members of other professions. The successful "2A will usually be an active community leader, well +nown in civic organi%ations, social clubs, educational circles, and many other related areas. The "2A not only attracts new clients but contributes to the advancement of the total environment in which the "2A$s professional talents are employed. The most difficult issue posed by 2ere% and Ferrer is whether the development of very close friendships between the "2A and staff on the one side and the client and staff on the other may cause the "2A to lose independence to some degree. This possibility cannot be easily dismissed. In assessing relationships with the client, the "2A must not only consider the fact of being independent, but also the recognition of independence by the public. The "2A must as+ the ,uestion4 /ould an outsider having full +nowledge of the relationships between the "2A and a client have doubts about the "2A$s independenceB This hard!to!define narrow path between cordial "2A!client relations on the one hand and the threat of loss of public confidence in the "2A$s independence on the other demands that the "2A exercise care and .udgment in social relationships with clients. 2artners, who by the very nature of their responsibilities must meet with business executives on their own ground, tend to develop social contacts with clients. 2resumably, partners in a public accounting firm have demonstrated the maturity, .udgment, and breadth of view that will enable them to maintain a proper balance between friendship with clients and professional independence. /hen the element of sex enters the picture, the formulation of precise rules of conduct becomes more difficult, if not impossible. Assume, for example, that a female executive and part owner of a client company and a male partner of the company$s public accounting firm are +nown to be constant companions during off business hours. The public would probably find it difficult to believe that the "2A would be truly independent in auditing the business in which his friend played such an important role.