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22 - 1 Prentice Hall Business Publishing, Prentice Hall Business Publishing, Auditing 11/e, Auditing 11/e, Arens/Beasley/Elder Arens/Beasley/Elder Internal and Internal and Governmental Governmental Financial Auditing Financial Auditing and Operational and Operational Auditing Auditing Chapter 26 Chapter 26

22 - 1 ©2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder Internal and Governmental Financial Auditing and Operational Auditing

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22 - 1©2006 Prentice Hall Business Publishing, ©2006 Prentice Hall Business Publishing, Auditing 11/e,Auditing 11/e, Arens/Beasley/Elder Arens/Beasley/Elder

Internal and Internal and GovernmentalGovernmentalFinancial Auditing and Financial Auditing and Operational AuditingOperational Auditing

Chapter 26Chapter 26

22 - 2©2006 Prentice Hall Business Publishing, ©2006 Prentice Hall Business Publishing, Auditing 11/e,Auditing 11/e, Arens/Beasley/Elder Arens/Beasley/Elder

Learning Objective 1Learning Objective 1

Explain the role of internalExplain the role of internal

auditors in financial auditing.auditors in financial auditing.

22 - 3©2006 Prentice Hall Business Publishing, ©2006 Prentice Hall Business Publishing, Auditing 11/e,Auditing 11/e, Arens/Beasley/Elder Arens/Beasley/Elder

Internal AuditingInternal Auditing

The New York Stock Exchange requires itsThe New York Stock Exchange requires itsregistrants to have an internal audit function.registrants to have an internal audit function.

22 - 4©2006 Prentice Hall Business Publishing, ©2006 Prentice Hall Business Publishing, Auditing 11/e,Auditing 11/e, Arens/Beasley/Elder Arens/Beasley/Elder

Internal AuditingInternal Auditing

It is an independent, objective assuranceIt is an independent, objective assuranceand consulting activity designed to addand consulting activity designed to addvalue and improve an organization’s operations.value and improve an organization’s operations.

It helps an organization accomplish its objectivesIt helps an organization accomplish its objectivesby bringing a systematic, disciplined approach toby bringing a systematic, disciplined approach toevaluate and improve the effectiveness of riskevaluate and improve the effectiveness of riskmanagement, control, and governance processes.management, control, and governance processes.

22 - 5©2006 Prentice Hall Business Publishing, ©2006 Prentice Hall Business Publishing, Auditing 11/e,Auditing 11/e, Arens/Beasley/Elder Arens/Beasley/Elder

Institute of Internal Auditors Institute of Internal Auditors Ethical PrinciplesEthical Principles

IntegrityIntegrity

ConfidentialityConfidentiality

ObjectivityObjectivity

CompetencyCompetency

22 - 6©2006 Prentice Hall Business Publishing, ©2006 Prentice Hall Business Publishing, Auditing 11/e,Auditing 11/e, Arens/Beasley/Elder Arens/Beasley/Elder

Relationship of Internal and Relationship of Internal and External AuditorsExternal Auditors

The The externalexternal auditor is responsible auditor is responsibleto financial statement users.to financial statement users.

The The internalinternal auditor is responsible auditor is responsibleto management.to management.

22 - 7©2006 Prentice Hall Business Publishing, ©2006 Prentice Hall Business Publishing, Auditing 11/e,Auditing 11/e, Arens/Beasley/Elder Arens/Beasley/Elder

Relationship of Internal and Relationship of Internal and External AuditorsExternal Auditors

CompetencyCompetency

MethodologyMethodology

ObjectivityObjectivity

Audit risk modelAudit risk model

22 - 8©2006 Prentice Hall Business Publishing, ©2006 Prentice Hall Business Publishing, Auditing 11/e,Auditing 11/e, Arens/Beasley/Elder Arens/Beasley/Elder

Learning Objective 2Learning Objective 2

Describe the auditing andDescribe the auditing and

reporting requirements underreporting requirements under

Government Auditing StandardsGovernment Auditing Standards

and the Single Audit Actand the Single Audit Act

22 - 9©2006 Prentice Hall Business Publishing, ©2006 Prentice Hall Business Publishing, Auditing 11/e,Auditing 11/e, Arens/Beasley/Elder Arens/Beasley/Elder

Governmental Financial AuditingGovernmental Financial Auditing

The primary source of authoritative literatureThe primary source of authoritative literaturefor performance of government audits isfor performance of government audits isGovernment Auditing StandardsGovernment Auditing Standards,,which is issued by the GAO.which is issued by the GAO.

Because of the color of the cover, it is usuallyBecause of the color of the cover, it is usuallyreferred to as the referred to as the ““Yellow BookYellow Book.”.”

22 - 10©2006 Prentice Hall Business Publishing, ©2006 Prentice Hall Business Publishing, Auditing 11/e,Auditing 11/e, Arens/Beasley/Elder Arens/Beasley/Elder

Governmental Financial AuditingGovernmental Financial Auditing

The Yellow Book standards are often calledThe Yellow Book standards are often calledgenerally accepted government auditinggenerally accepted government auditingstandards (GAGAS).standards (GAGAS).

22 - 11©2006 Prentice Hall Business Publishing, ©2006 Prentice Hall Business Publishing, Auditing 11/e,Auditing 11/e, Arens/Beasley/Elder Arens/Beasley/Elder

Financial Audit and Reporting Financial Audit and Reporting Requirements – Yellow BookRequirements – Yellow Book

Materiality and significanceMateriality and significance Quality controlQuality control Compliance auditingCompliance auditing ReportingReporting Audit filesAudit files

22 - 12©2006 Prentice Hall Business Publishing, ©2006 Prentice Hall Business Publishing, Auditing 11/e,Auditing 11/e, Arens/Beasley/Elder Arens/Beasley/Elder

Audit and Reporting – Single AuditAudit and Reporting – Single AuditAct and OMB Circular A-133Act and OMB Circular A-133

The threshold for requiring a single auditThe threshold for requiring a single auditwas raised from $100,000 to $300,000was raised from $100,000 to $300,000to exempt many smaller entitiesto exempt many smaller entitiesfrom single audit requirements.from single audit requirements.

The OMB increased the single auditThe OMB increased the single auditthreshold to $500,000 beginning in 2004.threshold to $500,000 beginning in 2004.

22 - 13©2006 Prentice Hall Business Publishing, ©2006 Prentice Hall Business Publishing, Auditing 11/e,Auditing 11/e, Arens/Beasley/Elder Arens/Beasley/Elder

Audit and Reporting – Single AuditAudit and Reporting – Single AuditAct and OMB Circular A-133Act and OMB Circular A-133

The office of Management and Budget issuedThe office of Management and Budget issueda revised Circular A-133, a revised Circular A-133, Audits of States,Audits of States,Local Governments, and Non-ProfitLocal Governments, and Non-ProfitOrganizationsOrganizations, , to provide administrativeto provide administrativeguidance for implementing theguidance for implementing thesingle audit requirements.single audit requirements.

22 - 14©2006 Prentice Hall Business Publishing, ©2006 Prentice Hall Business Publishing, Auditing 11/e,Auditing 11/e, Arens/Beasley/Elder Arens/Beasley/Elder

Audit RequirementsAudit Requirements

The audit should be in accordanceThe audit should be in accordancewith generally accepted governmentwith generally accepted governmentauditing standards (GAGAS).auditing standards (GAGAS).

The auditor must obtain an understandingThe auditor must obtain an understandingof internal control over federal programsof internal control over federal programssufficient to support a low assessedsufficient to support a low assessedlevel of control risk for major programs.level of control risk for major programs.

22 - 15©2006 Prentice Hall Business Publishing, ©2006 Prentice Hall Business Publishing, Auditing 11/e,Auditing 11/e, Arens/Beasley/Elder Arens/Beasley/Elder

Audit RequirementsAudit Requirements

The auditor should determine whether the clientThe auditor should determine whether the clienthad complied with laws, regulations, and thehad complied with laws, regulations, and theprovisions of contracts or grant agreementsprovisions of contracts or grant agreementsthat may have a direct and material effectthat may have a direct and material effecton each of its major programs.on each of its major programs.

22 - 16©2006 Prentice Hall Business Publishing, ©2006 Prentice Hall Business Publishing, Auditing 11/e,Auditing 11/e, Arens/Beasley/Elder Arens/Beasley/Elder

Reporting RequirementsReporting Requirements

An opinion as to whether the schedule ofAn opinion as to whether the schedule of federal awards is presented fairly in allfederal awards is presented fairly in all material respects in relation to thematerial respects in relation to the financial statements as a wholefinancial statements as a whole

An opinion on whether the financialAn opinion on whether the financial statements are in accordance with GAAPstatements are in accordance with GAAP

22 - 17©2006 Prentice Hall Business Publishing, ©2006 Prentice Hall Business Publishing, Auditing 11/e,Auditing 11/e, Arens/Beasley/Elder Arens/Beasley/Elder

Reporting RequirementsReporting Requirements

A report on internal control related to theA report on internal control related to the financial statements and major programsfinancial statements and major programs

A report on compliance with laws,A report on compliance with laws, regulations, and the provisions ofregulations, and the provisions of contracts or grant agreementscontracts or grant agreements

A schedule of findings and questioned costsA schedule of findings and questioned costs

22 - 18©2006 Prentice Hall Business Publishing, ©2006 Prentice Hall Business Publishing, Auditing 11/e,Auditing 11/e, Arens/Beasley/Elder Arens/Beasley/Elder

Operational AuditingOperational Auditing

The purpose of operational auditing is toThe purpose of operational auditing is todetermine the effectiveness or efficiencydetermine the effectiveness or efficiencyof any part of an organization.of any part of an organization.

22 - 19©2006 Prentice Hall Business Publishing, ©2006 Prentice Hall Business Publishing, Auditing 11/e,Auditing 11/e, Arens/Beasley/Elder Arens/Beasley/Elder

Learning Objective 3Learning Objective 3

Distinguish operational auditingDistinguish operational auditing

from financial auditing.from financial auditing.

22 - 20©2006 Prentice Hall Business Publishing, ©2006 Prentice Hall Business Publishing, Auditing 11/e,Auditing 11/e, Arens/Beasley/Elder Arens/Beasley/Elder

Differences between OperationalDifferences between Operationaland Financial Auditingand Financial Auditing

Distribution of the reportsDistribution of the reports

Inclusion of nonfinancial areasInclusion of nonfinancial areas

Purpose of the auditPurpose of the audit

22 - 21©2006 Prentice Hall Business Publishing, ©2006 Prentice Hall Business Publishing, Auditing 11/e,Auditing 11/e, Arens/Beasley/Elder Arens/Beasley/Elder

Learning Objective 4Learning Objective 4

Provide an overview ofProvide an overview of

operational audits.operational audits.

22 - 22©2006 Prentice Hall Business Publishing, ©2006 Prentice Hall Business Publishing, Auditing 11/e,Auditing 11/e, Arens/Beasley/Elder Arens/Beasley/Elder

EffectivenessEffectiveness refers to the accomplishment refers to the accomplishmentof objectives.of objectives.

Efficiency Efficiency is defined as reducing costs withoutis defined as reducing costs withoutreducing effectiveness.reducing effectiveness.

Effectiveness Versus EfficiencyEffectiveness Versus Efficiency

22 - 23©2006 Prentice Hall Business Publishing, ©2006 Prentice Hall Business Publishing, Auditing 11/e,Auditing 11/e, Arens/Beasley/Elder Arens/Beasley/Elder

Types of inefficiencyTypes of inefficiency ExampleExample

Acquisition of goods andAcquisition of goods andservices is too costly.services is too costly.

Bids for purchases ofBids for purchases ofmaterials are not required.materials are not required.

Raw materials are notRaw materials are notavailable when needed.available when needed.

An assembly line was shutAn assembly line was shutdown for lack of materials.down for lack of materials.

A duplication of effort byA duplication of effort byemployees exists.employees exists.

Production and accountingProduction and accountingkeep identical records.keep identical records.

Effectiveness Versus Efficiency

22 - 24©2006 Prentice Hall Business Publishing, ©2006 Prentice Hall Business Publishing, Auditing 11/e,Auditing 11/e, Arens/Beasley/Elder Arens/Beasley/Elder

Types of inefficiencyTypes of inefficiency ExampleExample

Work is done that serves noWork is done that serves nopurpose.purpose.

Vendors’ invoices andVendors’ invoices andreceiving reports are filedreceiving reports are filedwithout being used.without being used.

There are too manyThere are too manyemployeesemployees

Office work could be doneOffice work could be donewith one less assistant.with one less assistant.

Effectiveness Versus Efficiency

22 - 25©2006 Prentice Hall Business Publishing, ©2006 Prentice Hall Business Publishing, Auditing 11/e,Auditing 11/e, Arens/Beasley/Elder Arens/Beasley/Elder

Relationship between OperationalRelationship between OperationalAuditing and Internal ControlsAuditing and Internal Controls

Reliability of financial reportingReliability of financial reporting

Efficiency and effectiveness of operationsEfficiency and effectiveness of operations

Compliance with applicable laws and regulationsCompliance with applicable laws and regulations

22 - 26©2006 Prentice Hall Business Publishing, ©2006 Prentice Hall Business Publishing, Auditing 11/e,Auditing 11/e, Arens/Beasley/Elder Arens/Beasley/Elder

Types of Operational AuditsTypes of Operational Audits

FunctionalFunctional

OrganizationalOrganizational

Special assignmentsSpecial assignments

22 - 27©2006 Prentice Hall Business Publishing, ©2006 Prentice Hall Business Publishing, Auditing 11/e,Auditing 11/e, Arens/Beasley/Elder Arens/Beasley/Elder

CPA firmsCPA firms

GovernmentGovernmentauditorsauditors

InternalInternalauditorsauditors

Who Performs Operational AuditsWho Performs Operational Audits

22 - 28©2006 Prentice Hall Business Publishing, ©2006 Prentice Hall Business Publishing, Auditing 11/e,Auditing 11/e, Arens/Beasley/Elder Arens/Beasley/Elder

The two most important qualities forThe two most important qualities for an operational auditor are:an operational auditor are:

Independence and CompetenceIndependence and Competenceof Operational Auditorsof Operational Auditors

IndependenceIndependence CompetenceCompetence

22 - 29©2006 Prentice Hall Business Publishing, ©2006 Prentice Hall Business Publishing, Auditing 11/e,Auditing 11/e, Arens/Beasley/Elder Arens/Beasley/Elder

Learning Objective 5Learning Objective 5

Plan and perform an operationalPlan and perform an operational

audit.audit.

22 - 30©2006 Prentice Hall Business Publishing, ©2006 Prentice Hall Business Publishing, Auditing 11/e,Auditing 11/e, Arens/Beasley/Elder Arens/Beasley/Elder

Specific CriteriaSpecific Criteria

Were all plant layoutsWere all plant layouts approved by home office approved by home office engineering at the time of original design?engineering at the time of original design?

Has home office engineering done a reevaluationHas home office engineering done a reevaluationstudy of plant layout in the past five years?study of plant layout in the past five years?

22 - 31©2006 Prentice Hall Business Publishing, ©2006 Prentice Hall Business Publishing, Auditing 11/e,Auditing 11/e, Arens/Beasley/Elder Arens/Beasley/Elder

Specific CriteriaSpecific Criteria

Is each piece of equipment operating atIs each piece of equipment operating at60 percent of capacity or more for at60 percent of capacity or more for atleast three months each year?least three months each year?

Does layout facilitate the movement of newDoes layout facilitate the movement of newmaterials to the production floor?materials to the production floor?

Does layout facilitate the production of finishedDoes layout facilitate the production of finishedgoods?goods?

22 - 32©2006 Prentice Hall Business Publishing, ©2006 Prentice Hall Business Publishing, Auditing 11/e,Auditing 11/e, Arens/Beasley/Elder Arens/Beasley/Elder

Specific CriteriaSpecific Criteria

Does layout facilitate the movement of finishedDoes layout facilitate the movement of finishedgoods to distribution centers? goods to distribution centers?

Does the plant layout effectively use existingDoes the plant layout effectively use existingequipment?equipment?

Is the safety of employees endangered by theIs the safety of employees endangered by theplant layout?plant layout?

22 - 33©2006 Prentice Hall Business Publishing, ©2006 Prentice Hall Business Publishing, Auditing 11/e,Auditing 11/e, Arens/Beasley/Elder Arens/Beasley/Elder

Sources of CriteriaSources of Criteria

Historical performanceHistorical performance

BenchmarkingBenchmarking

Engineers standardsEngineers standards

Discussion and agreementDiscussion and agreement

22 - 34©2006 Prentice Hall Business Publishing, ©2006 Prentice Hall Business Publishing, Auditing 11/e,Auditing 11/e, Arens/Beasley/Elder Arens/Beasley/Elder

Phases in Operational AuditingPhases in Operational Auditing

PlanningPlanning

Evidence accumulation and evaluationEvidence accumulation and evaluation

Reporting and follow-upReporting and follow-up

22 - 35©2006 Prentice Hall Business Publishing, ©2006 Prentice Hall Business Publishing, Auditing 11/e,Auditing 11/e, Arens/Beasley/Elder Arens/Beasley/Elder

PlanningPlanning

• Scope of engagementScope of engagement

• StaffingStaffing

• Background informationBackground information

• Understand internal controlUnderstand internal control

• Decide on appropriate evidenceDecide on appropriate evidence

22 - 36©2006 Prentice Hall Business Publishing, ©2006 Prentice Hall Business Publishing, Auditing 11/e,Auditing 11/e, Arens/Beasley/Elder Arens/Beasley/Elder

Evidence Accumulation and Evidence Accumulation and EvaluationEvaluation

• DocumentationDocumentation

• Client inquiryClient inquiry

• ObservationObservation

22 - 37©2006 Prentice Hall Business Publishing, ©2006 Prentice Hall Business Publishing, Auditing 11/e,Auditing 11/e, Arens/Beasley/Elder Arens/Beasley/Elder

Reporting Follow-upReporting Follow-up

• Report usually sent to managementReport usually sent to management

• Tailored reportsTailored reports

• Follow-up on recommendationsFollow-up on recommendations with managementwith management

22 - 38©2006 Prentice Hall Business Publishing, ©2006 Prentice Hall Business Publishing, Auditing 11/e,Auditing 11/e, Arens/Beasley/Elder Arens/Beasley/Elder

Examples of Operational Audit Examples of Operational Audit FindingsFindings

• Outside janitorial firm saves $160,000Outside janitorial firm saves $160,000

• More timely credit memo processingMore timely credit memo processing

• Use the right toolUse the right tool

• Computer programs save manual laborComputer programs save manual labor

22 - 39©2006 Prentice Hall Business Publishing, ©2006 Prentice Hall Business Publishing, Auditing 11/e,Auditing 11/e, Arens/Beasley/Elder Arens/Beasley/Elder

End of Chapter 26End of Chapter 26