Internal and Governmental Financial Auditing and Operational Auditing Chapter 26 محمد أبو طواحينة شاكر الغلاييني أحمد إسليم

Learning Objective 1 Explain the role of internal auditors in financial auditing.

Internal Auditing Internal auditing is an independent objective assurance and consulting activity designed to add value and improve an organization’s operations. Risk Management Controls Governance Processes The New York Stock Exchange requires its registrants to have an internal audit function

Internal Auditing Provide value through improved operational effectiveness while performing traditional responsibilities. Reviewing management information Safeguarding assets Ensuring compliance

Institute of Internal Auditors Ethical Principles Integrity Ethical Principles Confidentiality Competence Integrity establishes trust and provides the basis for reliance on their judgment. Internal auditors make a balanced assessment of all the relevant circumstances and are not influenced by their own interests or by others in forming judgments. Internal auditors respect the value of information they receive and do not disclose information without appropriate authority. Internal auditors apply knowledge skills and experience needed in performing internal audit services. Objectivity

Institute of Internal Auditors Rules of Conduct Integrity Rules of Conduct Confidentiality Competency Internal auditors shall perform their work with honesty, diligence and responsibility. Internal auditors shall not participate in any activity or relationship that may impair their unbiased assessment. Internal auditors shall be prudent in the use of information acquired in the course of their duties. Internal auditors shall engage only in those services for which they have the necessary knowledge, skills, and experience. Objectivity

Relationship of Internal and External Auditors The internal auditor is responsible to management The external auditor is responsible to financial statement users Both must be competent, objective, use a similar methodology, and consider risk and materiality

Learning Objective 2 Describe the auditing and reporting requirements under Government Auditing Standards and the Single Audit Act

Governmental Financial Auditing The primary source of authoritative literature for performance of government audits is Government Auditing Standards, which is issued by the GAO. Because of the color of the cover, it is usually referred to as the “Yellow Book.”

Governmental Financial Auditing The Yellow Book standards are often called generally accepted government auditing standards (GAGAS). The financial auditing standards of the Yellow Book are consistent with the 10 generally accepted auditing standards of the AICPA.

Financial Audit and Reporting Requirements – Yellow Book Financial Auditing Standards of the Yellow Book Consistent with GAAS/ Provide additional guidance… Materiality and significance Compliance auditing Reporting

Audit and Reporting – Single Audit Act and OMB Circular A-133 The threshold for requiring a single audit is $500,000. The Single Audit Act and OMB Circular A-133 contain requirements for the scope of the audit. Compliance with GAGAS Internal Control Risk Legal Compliance The audit should be in accordance with generally accepted government auditing standards (GAGAS). The auditor must obtain an understanding of internal control over federal programs sufficient to support a low assessed level of control risk for major programs. The auditor should determine whether the client had complied with the laws, regulations, and the provisions of contracts or grant agreements that may have a direct and material effect on each of its major programs.

Reporting Requirements An opinion on … Statements in accordance with GAAP Schedule of federal awards A report on … An opinion on whether the financial statements are in accordance with GAAP An opinion as to whether the schedule of federal awards is presented fairly in all material respects in relation to the financial statements as a whole A report on internal control related to the financial statements and major programs A schedule of findings and questioned costs A report on compliance with laws, regulations, and the provisions of contracts or grant agreements Internal controls Legal Compliance Findings and Questioned costs

Learning Objective 3 Distinguish operational auditing from financial auditing.

Operational Auditing The purpose of operational auditing is to determine the effectiveness or efficiency of any part of an organization Financial Auditing emphasizes whether historical information was correctly recorded while operational auditing emphasizes effectiveness and efficiency The limited distribution of operational reports and the diverse nature of audits for efficiency and effectiveness allow operational reports to vary considerably from audit to audit.

Learning Objective 4 Provide an overview of operational audits.

Effectiveness Versus Efficiency Effectiveness refers to accomplishing objectives Efficiency is defined as reducing cost without reducing effectiveness

Effectiveness Versus Efficiency Inefficiency Example Acquisition of goods and services is too costly Bids for purchases of materials are not required Raw materials are not available when needed An assembly line was shut down for lack of materials A duplication of effort by employees exists Production and accounting keep identical records

Effectiveness Versus Efficiency Inefficiency Example Work is done that serves no purpose Vendors’ invoices and receiving reports are filed without being used There are too many employees Office work could be done with one less assistant

Relationship Between Operational Auditing and Internal Controls Reliability of financial reporting Efficiency and effectiveness of operations Compliance with applicable laws and regulations Internal control evaluation for financial auditing has two primary purposes: to determine the extent of substantive audit testing required and to report on the effectiveness of internal control over financial reporting. The scope of operational auditing concerns any control affecting efficiency or effectiveness while the scope of internal control evaluation for financial audits is restricted to the effectiveness of internal control over financial reporting and its effect on the financial statements.

Types of Operational Audits Functional Organizational A functional audit deals with one or more functions in an organization concerning the efficiency and effectiveness of the payroll function for a division or for the company as a whole. An organizational audit emphasizes how efficiently and effectively functions interact. Special assignments arise at the request of management for a wide variety of audits such as determining the cause of an ineffective IT system or investigating the possibility of fraud. Special assignments

Who Performs Operational Audits Internal auditors Government auditors Non-public companies often engage their CPA firm to do operational audits of one or more specific parts of its business. An example would be the efficiency and effectiveness of its computer systems. Public companies cannot engage their financial statement auditing firm to perform operational audits. Different federal and state government auditors perform operational audits as part of doing financial audits. Many internal audit departments do both operational and financial auditing. To maximize effectiveness, the internal audit department should report to the board of directors or president. CPA firms

Independence and Competence of Operational Auditors The two most important qualities for an operational auditor Competence Independence The independence of internal auditors is enhanced by having the internal audit department report to the board of directors or president. The auditor should not be responsible for operating functions in a company or for correcting deficiencies when ineffective or inefficient operations are found. While it is acceptable for auditors to recommend changes in operations, operating personnel (not the auditors) must have the authority to accept or reject those recommendations.

Learning Objective 5 Plan and perform an operational audit. A major challenge of operational auditing is in selecting specific criteria for evaluating whether efficiency and effectiveness have occurred.

Specific Criteria More specific criteria are usually desirable before starting an operational audit Sources of criteria include: Historical performance Benchmarking Engineered standards Discussion and agreement More specific criteria are usually desirable before starting an operational audit.

Phases in Operational Auditing Planning Evidence gathering and evaluation Reporting and follow-up The operational auditor must determine the scope of the engagement and communicate it to the organizational unit. The eight types of evidence are equally applicable to operational auditing. In operational audits, the report is usually sent only to management with a copy to the unit being audited. The diversity of operational audits requires a tailoring of each report to address the scope of the audit, findings, and recommendations. Eight types Documentation Staffing Scope Controls Scope Findings Recommendations

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