solman arens chapeter 26

8/12/2019 solman arens chapeter 26

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1Chapter 26

Internal and Governmental FinancialAuditing and Operational Auditing

Review Questions

26-1 Internal auditors who perform financial auditing are responsible forevaluating whether their company's internal controls are designed and operatingeffectively and whether the financial statements are fairly presented. Thisresponsibility is essentially the same as the responsibility of external auditors whoperform financial audits. The two types of auditors are also similar in that they bothmust be competent and must remain objective in performing their work andreporting their results. Despite these similarities the role of the internal auditor infinancial auditing differs from that of an external auditor in the following ways!

"ecause internal auditors spend all of their time with one companytheir knowledge about the company's operations and internal controlsis much greater than the external auditor's knowledge.#uidelines for performing internal audits are not as well defined asthe guidelines for external auditors.Internal auditors are responsible to the management of the companiesthat they work for while external auditors are responsible to financialstatement users."ecause internal auditors are responsible to management theirdecisions about materiality and risks may differ from the decisionsof external auditors.

26-2 The two categories of standards in the II$ International %tandards for the&rofessional &ractice of $uditing are 1( $ttribute %tandards and )( &erformance%tandards.

The Attribute Standards are!

&urpose authority and responsibilityIndependence and objectivity&roficiency and due professional care*uality assurance and improvement program

The Performance Standards are!

+anaging the internal audit activity,ature of work-ngagement planning&erforming the engagementommunicating results+onitoring progress+anagement/s acceptance of risks

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26- -xternal auditors are considered more independent than internal auditorsfor the audit of historical financial statements because their audit report isintended for the use of external users. 2rom an internal user's perspectiveinternal auditors are employees of the company being audited.

Internal auditors can achieve independence by reporting to the board ofdirectors or president. The responsibilities of internal auditors affect their

independence. The internal auditor should not be responsible for performingoperating functions in a company or for correcting deficiencies when ineffectiveor inefficient operations are found.

26-! #overnmental financial audits are similar to audits of commercial companiesin that both types of audits re3uire the auditor to be independent to accumulateand evaluate evidence and to apply generally accepted auditing standards#$$%(. The two types of audits are different because governmental financialaudits also re3uire the auditor to apply generally accepted governmental auditingstandards #$#$%( which are broader than #$$% and include testing forcompliance with laws and regulations. #overnmental financial auditing can be doneeither by auditors employed by federal and state governments governmentalauditors( or by &$ firms.

26-" The %ingle $udit $ct was created in 1456 to eliminate redundancy in theaudits of governmental agencies. The %ingle $udit $ct provides for a singlecoordinated audit to satisfy the audit re3uirements of all federal funding agencies.The %ingle $udit $ct was originally only applicable to audits of state and localgovernments but the re3uirements of the $ct were extended in 1447 to highereducation institutions and other not for profit organi8ations through the issuanceof 9+" ircular $ 1::.

26-6 The auditing standards of the ;ellow "ook are consistent with the ten

generally accepted auditing standards of the $I &$.%ome important additions and modifications are as follows!

Materiality and significance. The ;ellow "ook recogni8es thatacceptable audit risk and tolerable misstatement may be lower ingovernmental audits than in audits of commercial enterprises.Quality control. 9rgani8ations that audit government entities musthave an appropriate system of internal 3uality control and mustparticipate in an external 3uality control review program.Compliance auditing . The ;ellow "ook re3uires that the audit bedesigned to provide reasonable assurance of detecting materialmisstatements resulting from noncompliance with provisions ofcontracts or grant agreements that have a material and direct effecton the financial statements.Reporting . The audit report must state that the audit was made inaccordance with generally accepted government auditing standards.In addition the report on financial statements must describe thescope of the auditors' testing of compliance with laws and regulationsand internal controls and present the results of those tests or referto a separate report containing that information.

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26-6 #continued$

Audit files . The ;ellow "ook indicates that audit files should containsufficient information to enable an experienced reviewer with noprevious connection to the audit to ascertain from the audit filesevidence that supports the auditors' significant conclusions and

judgments.

26-% The primary specific objectives that must be incorporated into the designof audit tests under the %ingle $udit $ct are as follows!

$mounts reported as expenditures were for allowable services.


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26-1( The three major differences between financial and operational auditingare!

Purpose of the audit. 2inancial auditing emphasi8es whetherhistorical information was correctly recorded. 9perational auditingemphasi8es effectiveness and efficiency. The financial audit is

oriented to the past whereas an operational audit concernsoperating performance for the future.Distribution of the reports. 2or financial auditing the report

is typically distributed to many users of financial statements suchas stockholders and bankers. 9perational audit reports areintended primarily for management.

Inclusion of nonfinancial areas. 9perational audits cover anyaspect of efficiency and effectiveness in an organi8ation and cantherefore involve a wide variety of activities. 2inancial audits arelimited to matters that directly affect the fairness of financialstatement presentations.

26-11 -ffectiveness refers to the accomplishment of objectives whereasefficiency refers to the resources used to achieve those objectives. $n exampleof an operational audit for effectiveness would be to assess whether agovernmental agency has met its assigned objective of achieving elevator safetyin a city. $n example of efficiency is when two different production processesmanufacture a product of identical 3uality the process with the least cost isconsidered to be most efficient.

26-12 The following are the distinctions between the three kinds of operationalaudits and an example of each for a not for profit hospital!

)*+, OF O+,RA)IO.A/ A0 I) , A3+/, FOR A 4O +I)A/

Functional 2unctions are a means ofcategori8ing the activities of a businesssuch as the billing function or productionfunction. $ functional operational auditdeals with any of these functions.


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26-1 Internal auditors are in a uni3ue position to perform operational audits.They spend all of their time working for the company they are auditing. Theytherefore develop considerable knowledge about the company and its businesswhich is essential to effective operational auditing.

26-1! Different federal and state government auditors perform operational auditingoften as a part of doing financial audits. The most widely recogni8ed governmentauditors group is the >nited %tates #overnment $ccountability 9ffice #$9(. Inaddition each state has an $uditor #eneral's office that has similar responsibilitiesto the #$9. There are also auditors for most state treasury departments andvarious other state government auditors.

There are no significant differences between internal and governmentalauditors' roles and opportunities for operational auditing. Internal auditors ordinarilydo operational audits of for profit organi8ations whereas governmental auditorsperform the same role for governmental units.

26-1" It is common as a part of doing an audit of historical financial statementsfor &$ firms to also identify operational problems and make recommendationsthat may benefit the audit client. The recommendations can be made orally butthey are typically made by use of a management letter .

It is also common for the client to engage a &$ firm to do operationalauditing of one or more specific parts of its business. >sually such an engagementwould occur only if the company does not have an internal audit staff or if theinternal audit staff lacks expertise in a certain area. In most cases speciali8edmanagement services staff of the &$ firm rather than the auditing staff performsthese services. 2or example a private company may ask the &$ firm toevaluate the efficiency and effectiveness of its computer systems. $uditors ofpublic companies have to be especially cautious due to the prohibition of nonaudit services for public company audit clients.

26-16 riteria for evaluating efficiency and effectiveness in operational auditingmeans deciding the specific objectives that should have been achieved in theoperation being audited. >sually it is insufficient to state that the criteria are efficientand effective operations. +ore specific criteria are usually described. The followingare five possible specific criteria for evaluating effectiveness of an IT system forpayroll!

?as payroll completed and computer generated payroll checksprepared at least twelve hours before the payroll distribution deadlinein each of the past )0 weeks@?ere there two or less complaints by employees each week in thepast )0 weeks concerning incorrect paychecks that are attributableto the IT system@Is there a weekly review of the completed payroll by a person who is3ualified to evaluate whether the payroll is reasonable@Is the weekly error listing reviewed by the payroll system's analystto evaluate whether the payroll system should be changed@Does the IT payroll system for each branch office include the specificapplication controls for payroll that are recommended by the homeoffice@

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26-1% The three phases of operational auditing are planning evidenceaccumulation and evaluation and reporting and follow up. These phases havee3uivalents in historical financial statement audits but each phase is of coursesomewhat different given the focus on the audit of operations rather than theaudit of historical financial statements.

26-1& &lanning in an operational audit is similar to the audit of historicalfinancial statements. Aike audits of financial statements the operational auditormust determine the scope of the engagement and communicate that to theorgani8ational unit. It is also necessary to properly staff the engagement obtainbackground information about the organi8ational unit evaluate internal controlsand decide the appropriate evidence to accumulate.

The major difference between planning an operational audit and a financialaudit is the extreme diversity in operational audits. "ecause of the diversity it isoften difficult to decide on specific objectives of an operational audit. $notherdifference is that staffing is often more complicated in an operational audit than ina financial audit. This is because the areas covered by operational audits are

diverse and often re3uire special technical skills.26-1' Two major differences in operational and financial auditing affect operationalauditing reports. 2irst in operational audits the report is usually sent only tomanagement with a copy to the unit being audited. The lack of third party usersreduces the need for standardi8ed wording in operational auditing reports.%econd the diversity of operational audits re3uires a tailoring of each report toaddress the scope of the audit findings and recommendations.

3ultiple Choice Questions 5rom C+A , aminations

26-2( a. :( b. 6( c. )(

26-21 a. :( b. 1( c. :(

26-22 a. 6( b. 1( c. 6(

26-2 a. )( b. 6( c. :(

Cases

26-2! a. 9bjectivity means that the internal auditor must have and maintainan unbiased and independent viewpoint in the performance of audittests evaluation of the results and issuance of the audit findings.9bjectivity would not exist if the internal auditor were to audithisBher own work. 9bjectivity implies no subordination of judgmentto another and a lack of influence by others over the internal auditor.

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26-2! #continued$

b. 1. 9bjectivity is not impaired. Development of written policiesand procedures to guide Aajod's staff is a responsibility of theinternal audit staff. The internal auditors are responsible forthe independent evaluation and verification of proper internal

controls.). 9bjectivity is impaired. The preparation of bank reconciliationsis an internal check over cash. In order to maintain objectivitythe auditor should not perform assignments that are includedas part of the independent evaluation and verification of properinternal controls. %eparation of duties should be maintained.

:. 9bjectivity is not impaired in the review of the budget forreasonableness if the internal auditor has no responsibilityfor establishing or implementing the budget. 9bjectivity is alsonot impaired if the internal auditor merely reviews budgetvariances and explanations for those variances. 9bjectivity

would be impaired however if the internal auditor makesmanagerial decisions concerning performance in the reviewof variances.

6. 9bjectivity is impaired in that the internal auditor will be calledupon to evaluate the design and implementation of thesystem in which the auditor played a significant role. Testingof the internal controls would not impair objectivity becausethis activity is necessary for determining the ade3uacy ofaccounting and administrative controls.

=. 9bjectivity is impaired. The internal auditors should not beinvolved in the record keeping process.

c. 1. ;es the reporting relationship results in an objectivity problem.The controller is responsible for the accounting system andrelated transactions.

The internal audit staff is responsible for independentand objective review of the accounting system and relatedtransactions. Independence and objectivity may not existbecause the internal audit staff is responsible for reviewingthe work of the corporate controller the person to whom itreports.

). ,o the responses for re3uirement b would not be affected

by the internal audit staff reporting to an audit committeerather than the controller. In order to maintain objectivity theinternal audit staff should refrain from performing non auditfunctions such as management decision making design andinstallation of systems record keeping etc. Ideally the internalaudit staff should perform only audit functions to avoid beingcalled upon to evaluate its own performance. This is truewithout regard to organi8ational reporting relationships.

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26-2" a. $dditional steps that ordinarily should be taken by Aado orporation'sinternal auditors as a conse3uence of finding excessive turnover ina department of ?hite Division are categori8ed and explained below.

Field "or# The department turnover rate should be comparedwith rates in other departments of ?hite Division other divisions

of Aado orporation and industry rates if available. Thepresent department turnover rate should be compared withprevious rates in the department.

The nature of skills needed in the department shouldbe reviewed and compared to job descriptions if jobdescriptions exist. The hiring procedures employed by thepersonnel department should be reviewed as well as Aado'swages and benefits to determine if they are competitive.

The labor efficiency variance should be examined inan attempt to determine the portion attributable to inade3uatetraining. +ultiple standards or a new standard may be

appropriate. &resent and former departmental workers shouldalso be interviewed in an attempt to get additional points ofview on the problems of the department.

Recommendations The information gathered during theperformance of field work would form the basis for anyrecommendations. $udit findings would be included in theaudit report and unfavorable findings would lead in mostcases to recommendations.


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26-2" #continued$

b. The participation of the internal audit department in the computerfeasibility study including advising and concurring with the systemselected creates an objectivity problem. The internal audit departmentcould not accept an audit assignment involving the problems of the

existing computer system without placing themselves in a positionof conflict of interest.To eliminate the existing objectivity problem outside consultants

should be used to study the problems with the computer system. Toreduce future objectivity problems the internal audit departmentshould not perform functions that may place it in a position ofauditing its own work. $uditors should not assume a decisionmaking role as this will negate their future independence from thosedecisions.

c. 1. The location of Aado orporation's internal audit department

is inappropriate. Independence is the key to the work of theinternal auditor and is achieved through organi8ational statusand objectivity. $ Director of Internal $uditing should reportto a high level management executive in order to promoteindependence ensure ade3uate audit coverage and toassure the proper consideration of audit reports.

aving the Director of Internal $udits directly report tothe orporate ontroller is inappropriate. $ major portion ofthe internal auditor's responsibility involves the review of theaccounting function. Thus the Director may be far less thanobjective in evaluating the work of a superior.

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26-26 #continued$

a.

I 0,

1. The criteria used by the apital "udgeting #roup "#( need to beevaluated to determine whether they are consistent with askin's longterm goals and objectives.

). The internal controls in the capital budgeting process need to be evaluatedto determine whether the "# applied the criteria consistently.

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26-2%

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1. *uantities of materialsreceived are not verifiedby the materials manager.

"esides inspecting all incoming goods to ensurethat 3uality standards are met the materials managershould verify 3uantities received by actual physicalcount. $ll material receipts do not have to be countedfor a verification program to be effective. %ystematicallyverifying one or several receipts from each vendorduring a given time period can identify those receiptswhich are the most troublesome. 9nce identifiedefforts can be directed to correcting the problem. EThe verification process is performed by comparingreceiving document 3uantities to actual physicalcounts to ensure invoice totals are correct.

). The materials managerprepares purchasingre3uests based onproduction schedulesand not on re3uisitionsreceived from operatingdepartments.

&urchasing re3uests prepared by the materialsmanager are to be based on re3uisitions receivedfrom operating departments and not productionschedules for a four month period. &roductionschedules could be outdated and not reflect currentsales trends. 9perating departments are constantlyadjusting production levels to account for changes.To improve budgetary control over expenditures thecontroller's office also should review the re3uests inconjunction with forward planning to ensureexpenditures are consistent with company salesprojections. 9nce an analysis of inventory flows iscomplete the economic order 3uantity can be appliedto determine the reorder point and to minimi8einventories.

:. The majority of Aecimore'sre3uirement for a criticalraw material is suppliedby a single vendor.

It is best to develop alternate sources of supply forcritical materials. The obvious benefits are reducedreliance on a single vendor and the reducedpossibility of lost production because of materialshortages andBor other interruptions in the operationdue to a single vendor. -ncouragement ofcompetition by the effective allocation of materialre3uirements between vendors is also anotherbenefit that can be expected to materiali8e if an

effective program is implemented. 9ther benefitssuch as improved vendor services and technicalassistance may also result as vendors attempt togain increased shares of the goods provided theuser company.

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26-2% #continued$

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6.


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26-2&

a. -valuate the receipts versus the rent roll to search for any discrepanciescreate an expectation on overall level and individual level test some or allof the tenant payments over the year or extended if the owner desires.

b. 5 staff auditors are too many. There should be less staff and possiblyanother senior.

c. 2or objective F) the staff needs to interview all employees and flowchartor create a process memo detailing all of the duties. The audit team willthen need to evaluate and be sure that there is ade3uate segregation ofduties with such a small staff. If segregation of duties isn/t possible eitherhire another employee or be sure there is ade3uate owner involvementand owner review on a regular basis.

d. -xistence. This evidence shows that all items in the general ledger weredeposited into the bank. owever since existence cannot tell us if moneyis missing the test work needs to be altered.

e. Test work needs to address completeness. $lter test work! createexpectation based on rents expected to be collected at a high levelexpectation about rents to be collected from an individual.


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Internet +ro:lem olution; 0niversit< Internal Audit epartments

26-1 Just like large corporations many universities have internal audit departments. >niversity internal audit departments perform a range of services includingoperational and compliance audits audits of internal controls informationtechnology audits and audits of special programs on an as needed basis. Kisit

the website for the internal audit department at ?ashington >niversity at %t.Aouis Lhttp!BBinternalaudit.wustl.eduBindex.htmlM and answer the following 3uestions!

1. ?hat are the internal audit department/s responsibilities@

Answer; $ccording to the website! NThe Internal $udit Department is responsiblefor planning and performing internal audits at the >niversity. Internal

$udit assists management by providing independent and objectiveanalyses of activities and controls. $udit scopes can range from asingle process to all business activities in a division department or

school. Internal $udit makes recommendations as a result of thoseanalyses.O

). ?hat types of audits does the department perform@

Answer; $ccording to the website the department performs operational auditsfinancial audits compliance audits information technology auditsand system development audits.

:. ow does the internal audit department select areas for audit@

Answer; $ccording to the website! N$n annual audit plan is developed basedon risk assessment and in response to audit re3uests. niversity operating unitsand control functions to identify areas of potential institutional risk.In addition to planned audits the Internal $udit Department respondsto reports of fraudulent activities irregularities or mishandling of>niversity funds. Internal $udit is also consulted on new systemdevelopments or implementations. The audit plan is developedannually by the Director of Internal $udit. The plan is reviewed and

approved by the -xecutive Director of $udit and ompliance andthe $udit ommittee.O

.ote ! Internet problems address current issues using Internet sources. "ecauseInternet sites are subject to change Internet problems and solutions may change. urrentinformation on Internet problems is available at www.pearsonglobaleditions.comBarens.(

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solman arens chapeter 26