CHAPTER 3

GENERAL TYPES OF AUDIT

I. Review Questions

1. 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.

2. Refer to pages 43 to 45 of the textbook.

3. 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
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controls because plans, specified activities, standards, objectives, policies and
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.

4. 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.

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 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 do 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.

7. Five specific examples of operational audits that could be conducted by an

internal auditor in a manufacturing company are:
 General Types of Audit 3-3
1. Examination of employee time cards and personnel records to
determine if sufficient information is available to maximize the
effective use of personnel.
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 they
are being purchased at the lowest possible cost considering the quality
needed.
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 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

1. b 7. c 13. d 19. b
2. c 8. a 14. c 20. a
3. b 9. a 15. d 21. b
4. b 10. d 16. b
5. c 11. b 17. c
6. d 12. a 18. a

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 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 do not necessarily include all the inefficiencies that might
exist.
Case 2. a. 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
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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.

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 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 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 4. 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
 General Types of Audit 3-5
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 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 5. a. 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 do not exert an influence over the
internal auditor.

b. 1. 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.

2. 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.

3. 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.

4. 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
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impair objectivity, because this activity is necessary for determining 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. 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 because the
internal audit staff is responsible for reviewing the work of the
corporate controller, the person to whom the staff reports.

2. 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.

d. 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 do 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 6. 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 half-
century 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
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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.

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.
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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.