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 ABS-CBN Corporation, in which
the external auditors examine ABS-CBN’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 computerized
payroll-processing system is operating efficiently and effectively. An example
of a compliance audit would be a BIR auditor’s examination of an entity’s tax
return to determine the degree of compliance with the National Internal
Revenue Code.

2. Refer to pages 43 to 45 of the textbook.

3. 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 adequacy 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.
Organizations create internal auditing to serve or benefit the organization.

The broad objective of internal auditing is to provide assistance to members of

the organization to enable the members to meet their responsibilities
effectively. Assistance may involve providing counsel or recommendations,
analysis, or information. One 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,
3-2 Solutions Manual - Principles of Auditing and Other Assurance Services
objectives, policies, and goals. Such evaluations are really evaluations of
controls because plans, specified activities, standards, objectives, policies and
goals are controls. Internal auditors may be called on to examine areas for
which performance criteria have not been specified. When 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.

4. Independence is the essence of auditing and enables auditors to render

impartial and unbiased judgments. The two conditions that contribute to an
internal auditor’s independence are organizational status and auditor
objectivity. The internal auditors’ status must be such that they are respected
throughout the organization. Generally, the more respect management gives to
the internal audit function, the greater the attention the whole organization
pays to their findings and recommendations. Giving 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. Objectivity requires that internal auditors have an independent
mental attitude and an honest belief in their work product.

5. COA auditors perform operational or performance audits, compliance audits,

and financial audits.

6. An independent auditor is usually a CPA who has received a license to

perform the attest function. To be a CPA, one generally must meet certain
educational requirements and pass an examination.

Internal auditors are employees of the organization 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
organization.

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 required by law.

7. Five specific examples of operational audits that could be conducted by an

internal auditor in a manufacturing company are:
1. Examination of employee time cards and personnel records to
determine if sufficient information is available to maximize the
effective use of personnel.
 General Types of Audit 3-3
2. Review the processing of sales invoices to determine if it could be
done more efficiently.
3. Review the acquisitions of goods, including costs to determine if they
are being purchased at the lowest possible cost considering the quality
needed.
4. Review and evaluate the efficiency of the manufacturing process.
5. Review the processing of cash receipts to determine if they are
deposited as quickly as possible.

8. 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 risk
of material errors and irregularities is greatest, which provides a high level of
assurance that all material misstatements will be detected. However, it does
not provide a perfect guarantee that the audit will discover all material
misstatements.

II. Multiple Choice Questions

1. b 7. c 13. d 19. b
2. c 8. a 14. c 20. a
3. b 9. a 15. d 21. b
4. b 10. d 16. b
5. c 11. b 17. c
6. d 12. a 18. a

III. Comprehensive Cases

Case 1. a. The conglomerate should either engage the management advisory

services division of a CPA firm or its own internal auditors to conduct the
operational audit.

b. The auditors will encounter problems in establishing criteria for evaluating

the actual quantitative 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.
Case 2. a. The shareholder is correct in observing that internal auditors are quite
knowledgeable 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 quality to the financial statements prepared by
management. The quality ingredients are application of expert knowledge
of accounting principles, and impartiality in conducting the examination.
3-4 Solutions Manual - Principles of Auditing and Other Assurance Services
Moreover, the Securities and Exchange Act of 1934 requires that financial
statements of publicly held companies be examined by independent CPAs.

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. Management and stockholders are in
an adversarial relationship to one another. Management wishes to portray
financial position, results of operations, and cash flows in the most
favorable light. Stockholders require financial statements which fairly
present financial position, results of operations, and cash flows. Given this
conflict of interest, independent auditing evolved to serve as an
intermediary between management and stockholders and provide
reasonable assurance that the published financial statements fairly
represent management’s assertions. To maintain wide public acceptance
of audited financial statements, CPAs must be continually alert to any gap
in public vs. professional perceptions regarding responsibility of the CPA.
The Code of Ethics for Professional Accountants in the Philippines
constitute an effort to narrow the gap and respond more fully to public
expectations regarding the CPA’s role in providing professional services.

Case 3. a. The higher the level of reporting, the greater the authority possessed
by the unit to which the report is directed. Greater 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.

b. Some 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 weaknesses to the audit committee. Under
this type of arrangement, the audit committee typically has authority to
require timely correction of material weaknesses.

Case 4. a. Financial 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 making 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.
Operational auditing may be considered “input-oriented” while
management auditing focuses on output.

b. Management audits are a major function of the Commission on Audit,

which reports directly to Congress concerning the efficiency and
 General Types of Audit 3-5
effectiveness of government agencies and other entities engaged in
business with the government. As an arm of Congress, the Commission
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. Congressional decisions concerning increasing or
decreasing the level of funding, or even discontinuing a unit, are often
based largely on the findings of the COA.

Case 5. a. Objectivity 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. Objectivity
would not exist if the internal auditor were to audit his or her own work.
Objectivity implies that the internal auditor’s judgment is not subordinate
to the judgment of another and that others do not exert an influence over
the internal auditor.

b. 1. Objectivity is not impaired. Development of written policies and

procedures to guide Lee’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.

2. Objectivity is impaired. The preparation of bank reconciliations is a

control over cash. To maintain objectivity, the auditor should not
perform assignments that are included as part of the independent
evaluation and verification of proper internal control. Separation of
duties should be maintained.

3. Objectivity is not impaired in the review of the budget for

reasonableness if the internal auditor has no responsibility for
establishing or implementing the budget. However, objectivity is
impaired when the internal auditor makes managerial decisions
concerning performance in the review of variances.

4. Objectivity 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 objectivity, because this activity is necessary for
determining the adequacy of accounting and administrative controls.

5. Objectivity is impaired. The internal auditors should not be involved

in the recording process.

c. 1. Yes, the reporting relationship results in an objectivity problem. The

controller is responsible for the accounting system and related
transactions. The internal audit staff is responsible for independent
and objective review and examination of the accounting system and
3-6 Solutions Manual - Principles of Auditing and Other Assurance Services
related transactions. Independence and objectivity may not exist
because the internal audit staff is responsible for reviewing the work
of the corporate controller, the person to whom the staff reports.

2. No, 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 objectivity, the internal audit staff should refrain from
performing nonaudit functions, such as management decision making,
design and installation of systems, and recordkeeping. 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 organizational 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. Further, 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.

Sincerely,
Case 6. Perez is taking a very narrow view of the CPA’s role in the economy. The
reserved, aloof attitude recommended by Perez was perhaps justified a half-
century or more ago when the primary objective 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 speak 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 kind of
 General Types of Audit 3-7
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.

The auditors can be independent and objective without being cold and
impersonal. They should never convey the impression that they regard the
client’s employees as potential embezzlers. Neither should they take over
office equipment or accounting records in a manner that suggests lack 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 CPA partner as it is to the architect, the
physician, the attorney, and members of other professions. The successful
CPA will usually be an active community leader, well known in civic
organizations, social clubs, educational circles, and many other related areas.
The CPA not only attracts new clients but contributes to the advancement of
the total environment in which the CPA’s professional talents are employed.

The most difficult issue posed by Perez and Ferrer is whether the development
of very close friendships between the CPA and staff on the one side and the
client and staff on the other may cause the CPA to lose independence to some
degree. This possibility cannot be easily dismissed. In assessing relationships
with the client, the CPA must not only consider the fact of being independent,
but also the recognition of independence by the public. The CPA must ask the
question: Would an outsider having full knowledge of the relationships
between the CPA and a client have doubts about the CPA’s independence?
This hard-to-define narrow path between cordial CPA-client relations on the
one hand and the threat of loss of public confidence in the CPA’s
independence on the other demands that the CPA exercise care and judgment
in social relationships with clients. Partners, who by the very nature of their
responsibilities must meet with business executives on their own ground, tend
to develop social contacts with clients. Presumably, partners in a public
accounting firm have demonstrated the maturity, judgment, and breadth of
view that will enable them to maintain a proper balance between friendship
with clients and professional independence.

When 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 known to be constant companions
during off business hours. The public would probably find it difficult to
believe that the CPA would be truly independent in auditing the business in
which his friend played such an important role.