AUDB323 Audit & Investigation Semester 2, 2016-2017

Introduction to Internal Auditing

Introduction

1. Internal auditing is a separate and distinct branch of the accounting profession. The role of
internal auditing has become more significant in larger companies and is now seen as an
important management tool.

2. Because internal auditors spend all of their time with one company, their knowledge about the
companys operations and internal controls is much greater than the external auditors
knowledge.

3. The establishment of an internal audit function, especially in listed companies, is seen as good
corporate governance.

Definition

The Institute of Internal Auditors (IIAs) Definition of Internal Auditing:

Internal auditing is an independent, objective, assurance and consulting activity designed to add
value and improve an organizations operations. It helps an organization accomplish its objectives by
bringing a systematic, disciplined approach to evaluate and improve effectiveness of risk
management, control, and governance processes.

The above definition emphasizes on the importance of the internal auditing activity being
independent and objective if it is to be able to achieve its purpose of adding value and helping the
organization improve its operations.

Independence of the Internal Audit Function

Independence refers to the organizational status of the internal audit function. Independence is the
freedom from conditions that threaten objectivity or the appearance of objectivity.

For the internal audit function to be independent, it must report to a level within the organization
that has sufficient authority to enable it to carry out its function properly without undue influence
from other parties. It is recommended that the internal audit function reports directly to the BOD
and where it exists, to the audit committee.

Objectivity of Internal Auditors

Objectivity refers to the mental attitude of individual auditors. Individual objectivity is an impartial,
unbiased mental attitude and avoidance of conflicts of interest, allowing internal auditors to perform
engagements in such a manner that they have an honest belief in their work product and that no
significant quality compromises are made.

To ensure objectivity, internal auditors should not involve themselves in day-to-day operations, make
management decisions, or otherwise put themselves in situations that result in actual or potential
conflicts of interest.

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How Internal Auditing Adds Value

A well run internal audit function adds value in a number of ways, for example:

It acts as a training ground for future line managers, by exposing fast track members of the
department to a variety of situations, activities and functions within the organization.
It provides a one stop shop for best practice advice.
It provides an independent, objective opinion as to the quality of the business controls.
It stimulates risk awareness throughout the organization.
It is a source of qualified, experienced talent that can aid management in business improvement
programmes.
It provides specialist professional independent opinions on a variety of situations; such as due
diligence exercises.
It reports on fraudulent activity within the organization, with a view to understanding how it
happened and how to prevent it occurring again.
It ensures that the company wide initiatives, such as a code of conduct, are being adhered to.

Types of Internal Audit

In many large and complex companies, internal auditors might be asked to perform different types of
audits such as the following:

Financial auditing this would be concerned with the audit of items in the income
statement/statement of comprehensive income and statement of financial position. When the
internal auditors perform this type of work, they may duplicate work that the external auditors
might otherwise be expected to do. The external auditors might therefore be able to rely on the
work of the internal auditors in reaching their conclusion. This was considered in the earlier topic
on Auditors Reliance.

Compliance auditing this would be concerned with the compliance with policies and
procedures and internal controls (both financial and non-financial controls) as laid down by
management. Also concerned with compliance with various laws and regulations that have an
impact on the entitys business and operations (for e.g., environmental laws, health & safety
regulations, etc).

Efficiency auditing this would be concerned with determining whether resources are being
used efficiently. For example, the auditor would be interested in determining whether costs are
being minimized.

Effectiveness auditing this would be concerned with determining whether resources are being
used to proper effect. For example. The auditor might consider whether it would be better for
the entity to lease vans rather than purchase them outright.

Operational auditing this encompasses both efficiency and effectiveness. The idea is that the
auditor is concerned with the whole organization (i.e. concerned with all operational areas and
not just with those operational areas related to finance and accounting).

Energy audits these are checks on how the entity is making use of energy and whether its
operations are energy-efficient.

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Social audits these are checks on the impact of the entity on the society in which it operates.

Environmental audits these are checks on the effect the entity is having on its natural
environment, and considers issues such as the use of sustainable materials, re-cycling, reducing
pollution, and so on.

Human resource audits these are audits into the work force of an entity, to check whether the
entity has adequate systems for recruitment, training and development of employees to meet its
current and future needs.

Differences and Similarities with External Auditors

Different objectives

The objective of the external auditor is to form an opinion on the truth and fairness of the
financial statements and whether they are prepared in accordance with the relevant financial
reporting framework.

The prime objective of the internal auditor is to consider whether the companys existing
business practices are helping it to manage its risks and meet its business objectives it can
cover operational, non-operational, financial and non-financial matters.

Other differences

The external auditor is not an employee of the entity. Internal auditors work for and on behalf of
the entity.

Internal audit is not a legal requirement. It is a voluntary function which covers all the entitys
operations, not just the financial ones.

Internal auditors report to the board of directors or an audit committee. The external auditors
report to the shareholders.

Similarities

Both external and internal auditors carry out control testing and both are concerned that the
entity complies with the control procedures. However, the external auditor is more focused on
financial systems and the financial statements.

Both operate as professionals and both produce formal reports on their activities.

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Outsourced Internal Audit Services

Many companies have decided to outsource or contract out its internal audit function. This may
result in the external audit firm providing both the external and the internal audit function.

Advantages of outsourcing:

Some organizations are not large enough to warrant a separate internal audit department.
Outsourcing is therefore the only means by which they can benefit from the function.

The independence of the function is enhanced.

The investigation of sensitive areas such as management fraud is easier if outsourcing is used.

External providers may have more access to specialist knowledge.

But, disadvantages may include:

Outsourcing internal audit appears to go against the spirit of corporate governance which
regards regular monitoring of key controls by internal audit as an integral part of the entitys
system of controls.

Using external providers may be more expensive because they are paid fees which include a
profit element.

Staff of external providers may change frequently and the new staff will have to become
acquainted with the system. Internal staff usually know the system better and can therefore
identify the problems more easily. They are also closer to the daily activities of the entity and
may be able to anticipate problems earlier before they occur.

Using Internal Audit to Provide Direct Assistance

ISA 610 Using the Work of Internal Auditors permits the external auditor to use the internal auditor
for direct assiatance on the audit. Relying on the internal audit staff for the performance of some of
the audit testing may allow the audit to be completed in less time and for a lower fee.

When direct assistance is provided, the external auditor should assess the internal auditors
competence and objectivity. The work of the internal auditors should be directed, supervised,
reviewed and evaluated as appropriate under the circumstances.

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Review Questions

1. Define internal auditing.

2. Explain why external auditors might plan to use the work of internal audit for external audit
purposes?

3. Define independence and objectivity as they pertain to internal auditing.

4. How should the internal audit function be positioned within the organization so that it maintains
its independence?

5. What roles that you carry out in your capacity as the companys internal auditor might
compromise your objectivity?

6. How does an internal audit function add value to the organization?

7. Discuss the differences and similarities between internal and external auditing.

8. Discuss the advantages and disadvantages of outsourcing the internal audit function.

9. What are the ethical implications if the external audit firm provides both external and internal
audit services to the same audit client?

Tutorial Questions

Question 1
Explain the reasons why internal auditors should, or should not, report their findings on internal
control to the following selection of company officials:
(a) The finance director / CFO,
(b) The board of directors,
(c) The audit committee.

Question 2
Matalas Co sells cars, car parts and petrol from 25 different locations in one country. Each branch has
up to 20 staff working there, although most of the accounting systems are designed and
implemented from the companys head office. All accounting systems, apart from petty cash, are
computerised, with
the internal audit department frequently advising and implementing controls within those systems.

Matalas has an internal audit department of six staff, all of whom have been employed at Matalas for
a minimum of five years and some for as long as 15 years. In the past, the chief internal auditor
appoints staff within the internal audit department, although the chief executive officer (CEO) is
responsible for appointing the chief internal auditor. The chief internal auditor reports directly to the
finance director. The finance director also assists the chief internal auditor in deciding on the scope
of work of the internal audit department.

Required:
Explain the issues which limit the independence of the internal audit department in Matalas Co.
Recommend a way of overcoming each issue.

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Question 3
Lady Laila, a UK company, is a retailer of ladies clothing and accessories. It operates in many
countries around the world and has expanded steadily from its base in Europe. Its main market is
aimed at 15 to 35 year olds and its prices are mid to low range. The companys year end was 30
September 2015.

In the past the company has bulk ordered its clothing and accessories twice a year. However, if their
goods failed to meet the key fashion trends then this resulted in significant inventory write downs. As
a result of this the company has recently introduced a just in time ordering system. The fashion
buyers make an assessment nine months in advance as to what the key trends are likely to be, these
goods are sourced from their suppliers but only limited numbers are initially ordered.

Lady Laila has an internal audit department but at present their only role is to perform regular
inventory counts at the stores.

Required
Describe additional assignments that the internal audit department of Lady Laila could be asked to
perform by management and those charged with governance.