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CHAPTER 3

GENERAL TYPES OF AUDIT


Review Questions
1.Financial statements audits, operational audits, and compliance audits aresimilar in that each type of
audit involves accumulating and evaluatingevidence about information to ascertain and report on
the degree ofcorrespondence between the information and established criteria.
Thedifferences between each type of audit are the information being examined andthe criteria
used to evaluate the information.An example of a financialstatement audit would be the annual
audit of ABS-CBN Corporation, in whichthe external auditors examine ABS-CBNs financial
statements to determinethe degree of correspondence between those financial statements and
generallyaccepted accounting principles.An example of an operational audit would bean internal
auditors evaluation of whether the companys computerizedpayroll-processing system is
operating efficiently and effectively.An exampleof a compliance audit would be a BIR auditors
examination of an entitys taxreturn to determine the degree of compliance with the National
InternalRevenue Code.
2. Refer to pages 43 to 45 of the textbook.
3.The text defines internal auditing as an independent appraisal activity in anentity.Internal auditing
is itself a control that operates by examining andevaluating the adequacy and effectiveness of
other controls.Independence issuch 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 ofthe organization to
enable the members to meet their responsibilitieseffectively.Assistance may involve providing
counsel or recommendations,analysis, or information.One goal of internal auditing should be to
achieveeffective 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 auditings responsibility for examining andevaluating
performance to specific responsibilities that are assigned toindividuals or units.Internal auditing
examines and evaluates performance tocompare the actual performance with plans, specified
activities, standards,
objectives, policies, and goals.Such evaluations are really evaluations ofcontrols because plans,
specified activities, standards, objectives, policies andgoals are controls.Internal auditors may be
called on to examine areas forwhich performance criteria have not been specified.When this
occurs,internal auditors may select measurable criteria and report their findings interms of those
measurable criteria.For example, if internal auditors werecalled on to evaluate a credit
department, they might present historicalinformation as well as industry information to
management as a basis forevaluating the credit department.
4.Independence is the essence of auditing and enables auditors to renderimpartial and unbiased
judgments.The two conditions that contribute to aninternal auditors independence are
organizational status and auditorobjectivity.The internal auditors status must be such that they
are respectedthroughout the organization.Generally, the more respect management gives tothe
internal audit function, the greater the attention the whole organizationpays to their findings and
recommendations.Giving the highest-level personin internal auditing the status of vice president
and having that person report tothe board of directors audit committee give sufficient status to
the internalaudit function.Objectivity requires that internal auditors have an independentmental
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 toperform the attest
function.To be a CPA, one generally must meet certaineducational 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 operationalauditing.They are not
independent in the sense that external auditors are,although they may attain a degree of
independence by their position in theorganization.
Governmental auditors are employees of various government agencies who
perform financial, compliance, and operational auditing.For example, localgovernments employ
auditors to verify that businesses collect and remit salestax as required by law.
7.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 todetermine if sufficient information is
available to maximize theeffective use of personnel.

General Types of Audit3-3
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 theyare being purchased at the
lowest possible cost considering the qualityneeded.
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 theauditor does the best
audit possible.Auditors focus on the areas where the riskof material errors and irregularities is
greatest, which provides a high level ofassurance that all material misstatements will be
detected.However, it doesnot provide a perfect guarantee that the audit will discover all
materialmisstatements.
Multiple Choice Questions
1. b
2. c
3. b
4. b
5. c
6. d
7. c
8. a
9. a
10. d
11. b
12. a
13. d
14. c
15. d
16. b
17. c
18. a
19. b
20. a
21. b
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 evaluatingthe actual quantitative
events and in setting the scope to include alloperations in which significant inefficiencies might
exist.In writing thereport, the auditors must choose proper wording to state that no financialaudit
was performed, that the procedures were limited in scope and thatthe results reported do not
necessarily include all the inefficiencies thatmight exist.
Case 2.a.The shareholder is correct in observing that internal auditors are quite
knowledgeable about the company; and that the internal auditors couldperform the audit at less
cost than independent auditors.But the fact thatthey are not independent precludes the internal
auditors from completingthe annual audit.The independent auditor represents financial statement
users, and adds quality to the financial statements prepared bymanagement.The quality
ingredients are application of expert knowledgeof 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.
b.Independent auditing exists as a profession because the public hasperceived a need for an impartial
examination of financial statementsissued by publicly held companies.Management and
stockholders are inan adversarial relationship to one another.Management wishes to
portrayfinancial position, results of operations, and cash flows in the mostfavorable
light.Stockholders require financial statements which fairlypresent financial position, results of
operations, and cash flows. Given thisconflict of interest, independent auditing evolved to serve
as anintermediary between management and stockholders and providereasonable assurance that
the published financial statements fairlyrepresent managements assertions.To maintain wide
public acceptanceof audited financial statements, CPAs must be continually alert to any gapin
public vs. professional perceptions regarding responsibility of the CPA.The Code of Ethics for
Professional Accountants in the Philippinesconstitute an effort to narrow the gap and respond
more fully to publicexpectations regarding the CPAs 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 theprobability to prompt
implementation of the auditors recommendations.To this end, many companies have their
internal auditors report directly tothe chief executive officer.
b.Some companies assign responsibility for coordinating the system ofinternal control to the audit
committee of the board of directors. Theinternal auditors, under these circumstances, may serve
as liaison byreporting discovered control weaknesses to the audit committee.Underthis type of
arrangement, the audit committee typically has authority torequire timely correction of material
weaknesses.
Financial auditing involves examining financial statements and
attesting to the fairness of financial presentation; operational auditingrelates to the study and
evaluation of operating activities for the purposeof identifying inefficiencies and making
recommendations forimprovement; management auditing is an extension of operationalauditing
in that the auditor assesses management effectiveness inachieving entity goals, as well as
evaluating operating efficiency.Operational auditing may be considered input-oriented
whilemanagement auditing focuses on output.
Management audits are a major function of the Commission on Audit,
which reports directly to Congress concerning the efficiency and

General Types of Audit3-5
effectiveness of government agencies and other entities engaged inbusiness with the
government.As an arm of Congress, the Commissionon Audit has the authority to examine
virtually any agency.Theseexaminations typically assume the form of management audits
wherebythe auditors assess the efficiency and effectiveness with which the agencyis being
operated.Congressional decisions concerning increasing ordecreasing the level of funding, or
even discontinuing a unit, are oftenbased largely on the findings of the COA.
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.Objectivitywould not exist if the internal auditor were to audit
his or her own work.Objectivity implies that the internal auditors judgment is not subordinateto
the judgment of another and that others do not exert an influence overthe internal auditor.
b.1.Objectivity is not impaired.Development of written policies andprocedures to guide Lees staff is a
responsibility of the internal auditstaff.The internal auditors are responsible for the
independentevaluation and verification of a proper system of internal control.
2.Objectivity is impaired.The preparation of bank reconciliations is acontrol over cash.To maintain
objectivity, the auditor should notperform assignments that are included as part of the
independentevaluation and verification of proper internal control.Separation ofduties should be
maintained.
3.Objectivity is not impaired in the review of the budget forreasonableness if the internal auditor has
no responsibility forestablishing or implementing the budget.However, objectivity isimpaired
when the internal auditor makes managerial decisionsconcerning performance in the review of
variances.
4.Objectivity is impaired in that the internal auditor will be called on toevaluate the design and
implementation of the system in which he orshe played a significant role.Testing of the internal
controls wouldnot impair objectivity, because this activity is necessary fordetermining 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.Thecontroller is responsible for the
accounting system and relatedtransactions.The internal audit staff is responsible for
independentand objective review and examination of the accounting system and
related transactions.Independence and objectivity may not existbecause the internal audit staff is
responsible for reviewing the workof the corporate controller, the person to whom the staff
reports.
2.No, the responses forb would not be affected by the internal auditstaffs reporting to an audit
committee rather than the controller.Tomaintain objectivity, the internal audit staff should refrain
fromperforming nonaudit functions, such as management decision making,design and
installation of systems, and recordkeeping.Ideally, toavoid being called on to evaluate its own
performance, the internalaudit staff should perform only audit functions.This is true
withoutregard to organizational reporting relationships.
d.Dear President:
We recommend that the manager of internal audit report tothe vice president rather than the
controller.A large part ofthe work of the internal auditors do involves anexamination of the
accounting system and relatedtransactions which are functions for which the controller
isdirectly responsible.
If the manager of internal auditreports to the controller, the
controller may prevent theinternal auditors from looking at issues that need to
beexamined.Further, the internal audit manager may feelcompelled to avoid being completely
candid about mattersunder 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 CPAs 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 thediscovery of errors, defalcations, and other
forms of fraud.
In the current era, the auditors role has changed from that of a detective tothat of accounting
experts whose breadth of experience in the audit of manycompanies enables them to offer clients
constructive advice which leads tocompliance with accounting principles, improved accounting
methods, betterfinancial administration, and more profitable operation.

To fulfill this broader role of advisers as well as impartial reviewers, theauditors need the
cooperation of client personnel at all levels.They needmanagers and employees to speak freely of
their problems and to explain fullywhy certain operating methods are followed.The audit will be
far moreeffective if client personnel are willing to identify problem areas.This kind of
two-way communication between the client and the auditors will be possibleonly if the client
views the auditors as approachable, cordial individuals with asincere interest in helping the
client.
The auditors can be independent and objective without being cold andimpersonal.They should
never convey the impression that they regard theclients employees as potential
embezzlers.Neither should they take overoffice equipment or accounting records in a manner
that suggests lack ofconsideration for the convenience and status of the clients staff.
The development of social relationships with the client outside the office, asadvocated by Ferrer,
is helpful to the CPA partner as it is to the architect, thephysician, the attorney, and members of
other professions.The successfulCPA will usually be an active community leader, well known in
civicorganizations, social clubs, educational circles, and many other related areas.The CPA not
only attracts new clients but contributes to the advancement ofthe total environment in which the
CPAs professional talents are employed.
The most difficult issue posed by Perez and Ferrer is whether the developmentof very close
friendships between the CPA and staff on the one side and theclient and staff on the other may
cause the CPA to lose independence to somedegree.This possibility cannot be easily dismissed.In
assessing relationshipswith 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
thequestion:Would an outsider having full knowledge of the relationshipsbetween the CPA and a
client have doubts about the CPAs independence?
This hard-to-define narrow path between cordial CPA-client relations on theone hand and the
threat of loss of public confidence in the CPAsindependence on the other demands that the CPA
exercise care and judgmentin social relationships with clients.Partners, who by the very nature of
theirresponsibilities must meet with business executives on their own ground, tendto develop
social contacts with clients.Presumably, partners in a publicaccounting firm have demonstrated
the maturity, judgment, and breadth ofview that will enable them to maintain a proper balance
between friendshipwith clients and professional independence.
When the element of sex enters the picture, the formulation of precise rules ofconduct becomes
more difficult, if not impossible.Assume, for example, thata female executive and part owner of
a client company and a male partner ofthe companys public accounting firm are known to be
constant companionsduring off business hours.The public would probably find it difficult
tobelieve that the CPA would be truly independent in auditing the business inwhich his friend
played such an important role.