CHAPTER GENERAL TYPES OF AUDIT I Review Questions 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 Refer to pages 43 to 45 of the textbook 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, objectives, policies, and goals Such evaluations are really evaluations of controls because plans, specified activities, standards, objectives, policies and 3-2 Solutions Manual - Principles of Auditing and Other Assurance Services 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 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 COA auditors perform operational or performance audits, compliance audits, and financial audits 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 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 Five specific examples of operational audits that could be conducted by an internal auditor in a manufacturing company are: Examination of employee time cards and personnel records to determine if sufficient information is available to maximize the effective use of personnel Review the processing of sales invoices to determine if it could be done more efficiently General Types of Audit 3-3 Review the acquisitions of goods, including costs to determine if they are being purchased at the lowest possible cost considering the quality needed Review and evaluate the efficiency of the manufacturing process Review the processing of cash receipts to determine if they are deposited as quickly 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 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 b c b b c d 10 11 12 c a a d b a 13 14 15 16 17 18 d c d b c a 19 b 20 a 21 b III Comprehensive Cases Case 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 not necessarily include all the inefficiencies that might exist 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 Moreover, the Securities and Exchange Act of 1934 requires that financial statements of publicly held companies be examined by independent CPAs Case a 3-4 Solutions Manual - Principles of Auditing and Other Assurance Services 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 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 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 effectiveness of government agencies and other entities engaged in business with the government As an arm of Congress, the Commission General Types of Audit 3-5 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 a b c 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 not exert an influence over the internal auditor 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 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 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 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 Objectivity is impaired The internal auditors should not be involved in the recording process 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 related transactions Independence and objectivity may not exist 3-6 Solutions Manual - Principles of Auditing and Other Assurance Services because the internal audit staff is responsible for reviewing the work of the corporate controller, the person to whom the staff reports d 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 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 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 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 halfcentury 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 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 General Types of Audit 3-7 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 ... of publicly held companies be examined by independent CPAs Case a 3-4 Solutions Manual - Principles of Auditing and Other Assurance Services b Independent auditing exists as a profession because... 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...3-2 Solutions Manual - Principles of Auditing and Other Assurance Services goals are controls Internal auditors may