Lonni Steven Wilson, Medaille College chapter 16 Auditing

Key Chapter Objectives Define the purposes of auditing. Understand the problems associated with poor auditing. Describe the types of audits. Understand the importance of selecting competent and unbiased auditors.

Key Terms audit—An inspection by an independent external entity of all of a company’s accounting records and business operations. fraud—Dishonesty in business dealings. It may take many forms, including theft of money, theft of merchandise, or the inaccurate reporting of work times.

Auditing Auditing is one of the most important areas within the field of accounting. It is designed to identify problems and ensure investor confidence. Purposes To ensure that all financial statements accurately portray a firm’s financial position To allow managers to analyze their operation’s efficiency

Ensuring the Accuracy of Information Financial statements –The ratios are only as good as the numbers used in the ratios. Analyzing a business’ internal processes to see whether they successfully control the flow of financial information

Analyzing Operational Efficiency Audits may detect areas in which a sport business operates more efficiently, which could lead to an increase in profits (Arens & Loebbecke, 2006). For example, efficient use of funds will allow an athletic director to maximize the number of opportunities for the coaches and student-athletes.

Categories of Audits Internal Audits are completed by staff members within a business. Most large businesses have a financial department that oversees internal audits. Internal auditor helps to ensure accuracy and to develop internal controls. Independent An external review of the finances by individuals who are not directly involved with the documents that are being reviewed Can be performed by someone from another division in the company who has not been involved in generating the document that is being reviewed or by external entities (most common type). IRS audits: Outside the scope of our focus

Legal but Not Honest Many companies “play games” with financial statements to present an interpretation of the data that shows the company in the best light. The auditor must make sure these tricks are properly recorded and communicated to all interested parties. Some of the tricks are legal, but they are not necessarily honest. (continued)

Legal but Not Honest (continued) Examples include the following: Companies might promote their earnings by publicizing a pro forma figure that excludes many normal expense items such as interest and marketing expenses. If the earnings are low or negative, a company might list instead EBITDA—earnings before interest, taxes, depreciation, and amortization. Companies might not report the potential impact of stock-options grants on their earnings.

Legal Need for Accuracy in the Auditing Process Under U.S. common law and securities law, third parties such as investors, creditors, and government agencies can sue independent auditors. Monetary damages may have to be paid if it is determined that the independent auditor is guilty of a crime (Whittington & Pany, 2006).

Table 16.1 Types of Independent Audits Type of audit Role of auditAudit tasks Financial statement audit Ensure the accuracy of financial statements Review documents, records, and other sources of financial evidence Operational audit Evaluate the efficiency and effectiveness of organizational activities Interview employees; analyze processes and written reports Compliance audit Determine if specific rules, procedures, or regulations set by higher authorities are being met Analyze written materials, stated regulations and standards, and methods for meeting these regulations and standards Integrated audit Assure both the effectiveness of internal financial reporting and the accuracy of completed financial statements Document both the accuracy of the financial statements and the management's effectiveness in internally controlling the accounting processes

Benefits of Independent Audits for Auditees Independent audits provide credibility and reliability to financial statements. Audits dissuade management and employees from committing acts of fraud. Audited financial statements lessen the likelihood of government audits by ensuring that the basis for the preparation of tax returns and other financial documents is accurate. Audited financial statements increase investor or creditor confidence and broaden the sources of outside financing. Independent audits uncover errors in the auditee’s financial records, which may lead to the recovery of lost revenue or may decrease costs. Independent audits ensure that the business is consistently following stated policies and procedures.

Benefits of Independent Audits for the Business Community Audited financial statements give vendors and other creditors a credible basis for making decisions about extending credit. Audited statements are a credible basis on which potential and current investors can evaluate investment and management performance. Audited statements provide insurance companies a credible and accurate basis for settling claims for insurance-covered losses. Audited statements provide labor unions and the auditee an objective basis on which to settle disputes over wages and fringe benefits. Audited statements provide the buyer and seller a basis for negotiating the terms for the sale or merger of business entities.

Benefits of Independent Audits for Government Entities and the Legal Community Government agencies gain additional assurance concerning the dependability and accuracy of tax returns and financial reports. Independent audits of financial statements from public interest organizations such as banks and public utilities provide government agencies with an independent means to focus their special examination resources. Audited financial statements give the legal community an independent basis for settling bankruptcy actions.

The Auditing Process Selecting an auditor Preparing for the auditor –internally prepared documents –externally prepared documents –nonfinancial records –making personnel available for oral interviews The auditor onsite –cash auditing (how cash is handled) –inventory auditing (what inventory exists and how it is handled) –plant, property, and equipment auditing –payroll auditing Receiving the auditor’s report

Methods of Dealing With Fraud Segregation of duties –Duties such as depositing cash and reconciling bank accounts should be given to different staff members. Inventory of assets –To prevent stolen assets such as plant, property, and equipment, a business should undergo periodic inventory checks. (continued)

Methods of Dealing with Fraud (continued) Mandated vacations –Each employee should use at least a portion of her allotted vacation time each year. –Some fraud cases, especially with cash, occur on a recurring or daily basis. –It is much easier to detect the fraud if the employee is away from the business for an extended period of time. (continued)

Methods of Dealing with Fraud (continued) Analytical procedures –Simple analytical procedures such as tracking the daily deposits, weekly sales, and monthly sales totals may be enough to uncover some fraud. Practical considerations –For a small business, the first four recommendations may be difficult to implement. –A small business owner may take practical steps such as requesting that his bank send the business’ bank statements to his home address instead of to the business.

Questions for In-Class Discussion 1.How can you balance the need for making sure accounts are accurate and the need to allow individuals to work without the fear that someone is watching their every move? 2.Why is accuracy so important? 3.Why should you choose an independent auditor versus an internal auditor? 4.Is it ethically correct to “permanently borrow” office supplies? 5.How would you approach someone if you thought that person had engaged in fraud?