This paper gives a broad description of an auditing profession and all matters that are connected with this area.

 

 2.1 What is auditing?

Auditing is a very broad term; it includes many dimensions of the auditing profession. In general “auditing is the accumulation and evaluation of evidence about information to determine and report on the degree of correspondence between the information and established criteria.”(Arens, 2000, p.9)

According to the definition above, to perform auditing there must be information in a form, which is easy to analyse and some criteria on the basis of which the auditor can evaluate available information. These criteria vary depending on the nature of the analysied data. For example, audit of financial statements are based on the generally accepted accounting rules.

Auditing is a kind of an assurance service, so it improves a quality of the information for decision making process. Within assurance services we can distinguish a group of attestation services that auditing also belongs to. They are performed by firms providing auditing services, so called CPA firms (Certified Public Accountants) and result in issuing a communication in a written form that expresses a conclusion about the reliability of a written assertion of another party.(Arens, 2000, p.6)

Non-attestation services are these that do not result in the expression of an opinion or some kind of assurance. They are connected with traditional accounting, taxation, management consulting or advisory, insolvency and business recovery.

(Cosserat, 2000, p.17)

There are three main types of auditing: operational auditing, compliance auditing and the most popular – financial statements audits.

1. Operational auditing (value-for-money audit) involves obtaining and evaluating evidence about the efficiency and effectiveness of the organisation’s operating procedures. This is quite difficult to evaluate  the effectiveness and efficiency in objective terms so established criteria in this case are usually set in a subjective way.
2. Compliance auditing, which is to determine whether the analysed company or individual person for example a tax payer, conforms to procedures, rules or regulations established by authorities.
3. Financial statements audit, which is the most popular and common type of auditing. It involves obtaining and evaluating evidences about the company’s financial situation and financial or non-financial affairs that took place in the analysing period, which is usually a calendar year. The main goal is to state whether the financial statement was made in accordance to generally accepted accounting principles in the country that law is obligatory for the company to follow. What is more, the auditor checks if the evidences are properly registered and reflected in the statement. Financial statement that is analysed consists of: statement of financial position (balance), income statement, statement of cash flows if it is obligatory for the company to prepare it and additional information (footnotes). (Arens, 2000, p.11-12)

2.2 Why do we need audit of financial statements?

Audit of financial statements is performed by external auditors chosen by shareholders of the company or by equivalent proprietors of non-incorporated company. After examination of all of the evidence, the auditor issues an opinion in a form of the report, which is delivered to shareholders together with the final version of financial statements that was examined.

The need for financial statements audits results from a few reasons. First of all, there is a conflict of interest among management and shareholders or shareholders and creditors. In this case auditing provides reliability and neutral examination of financial data that are used in the decision making process.

Another reason is the existence of law regulations that require some companies to audit their financial statements. For example public limited companies that place their shares on the Stock Exchange are obliged to give their financial statements for independent auditing.

Necessity to audit financial statements results also from the complexity connected with preparing financial statements. It can cause unintential errors or misinterpretations and that is why users of those statements seek to opinion of the external professional auditors.

Finally there is also remoteness of financial data on the basis of which financial statements are prepared. Users do not have an access to this information as it is generally company’s confidential data. That is why they prefer to rely on the attestation of the external auditor than just accept the financial statement in good faith.(Cosserat, 2000, p.39)

2.3 What is the added value of audited financial statements?

Undoubtly, a financial statement that is examined and evaluated by an external, independent from the company, auditor is more reliable for its users who are usually shareholders or creditors. Auditing adds credibility to the financial statement prepared by company’s accountants under supervision of management. Financial statements are necessary for shareholders to make decisions concerning company and to control its performance. After its examination by an auditor, they have trust that figures, included in the statements are reliable and reflect the real financial situation of the company. Auditing helps to limit an information risk that follows the process of preparing the financial statement.(Arens, 2000, p.9)

2.4 Conclusions

There are many types of auditing and assurance services. The market for these services is still growing and they are more and more connected to the development in technology. CPA firms use sophisticated methods  and procedures in provided auditing services. Audits are valuable because they reduce information risk, which lowers the cost of obtaining capital. (Arens, 2000, p.15)

Chapter 3: Internal control

3.1 What is  an internal control system?

Internal control system consists of both: financial and non-financial controls. It is set up by management of a company to carry out the business of the company in an orderly and efficient way. The system should ensure that records of the company are complete and accurate and that management is conducting a proper policy.

An internal control system is very important for a company in order to prevent it from frauds or material loses.

Management of the company is responsible to establish and implement system of an internal control but all the employees are involved into the system. It is designed to manage rather than eliminate the risk of failure to achieve policies. It can provide reasonable but not absolute assurance of effectiveness.

(Cosserat, 2000, p.231)

3.2 Description of an internal control system

Internal control system is a series of actions and that are integrated with a company’s structure. It is a process, affected by people. The elements within the system  can be divided into:

1. The accounting system
2. Control procedures
3. Control environment

3.2.1 The accounting system

Different companies have accounting systems adherent to their needs. An auditor must understand this system before starting examination of financial statement. Internal control system in this area should be focused on ensuring that the transactions are properly conducted and recorded. It protects from mistakes in financial statements. It is important for an effective accounting system to record transactions in the period they should be stated. The main emphasis auditors put rather on controls over transactions than on the account balances. (Cosserat, 2000, p.232)

3.2.2 Control procedures

These are procedures that management is setting up in order to ensure that specific goals of the company will be achieved. Control procedures can be divided into:

1. Information processing procedures – these are controls connected with limiting the risk related to authorisation, completeness and accuracy of transactions.

1. General controls – they are connected with the efficiency of computer accounting system and maintaining it in a ‘good shape’.
2. Application controls – these controls are connected with specific transactions and can be divided into more particular ones:

• Authorisation – these procedures are for ensuring that adequate employees authorize transactions and for limiting access to documents, records and assets.
• Documents and records – the procedures are set up to maintain adequate record keeping, to ensure that all transactions are recorded and they are recorded only once.
• Independent checks – they involve verification of work already completed and proper valuation of recorded amounts.

2. Segregation of duties – it is to ensure that employees do not perform incompatible duties.
3. Physical controls – they are to limit access to assets and important records in order to protect them from damage or stealing.
4. Independent checks on performance – they are necessary to review how internal control procedures are fulfilled by individuals.

(Cosserat, 2000, p.233-234)

3. Control environment

Control environment is in general the overall set of actions and awareness of management that concern internal control. There are many elements included in the control environment.

1. Integrity and ethical values
2. Commitment to competence
3. Management’s philosophy and operating style
4. Organisational structure
5. Assignment of authority and responsibility
6. Internal audit
7. Use of information technology
8. Human resource policies and practices
9. board of directors and audit committee (Arens, 2000, p.293)

2. Importance of an internal control system for an auditor

Management has three main concerns while establishing an internal control system:

1. Reliability of financial statements
2. Compliance with applicable laws and regulations
3. Efficiency and effectiveness of operations

Internal control system is an important dimension of the company that must be examined and understood by an auditor before starting audit in an entity.

The most interesting field of controls for an auditor is the first one, which concerns reliability of financial statements. Auditors have a responsibility for discovering all misappropriations of assets (frauds) or other discrepancies. If internal controls are properly established and designed, they can protect from frauds or help in detecting them. (Arens, 2000, p.290)

Effective internal controls can reduce seriously planned audit evidence. The figure below shows that understanding internal control and assessing control risk in one of the parts of the whole audit process.

Figure 1: Summary of the audit process

Source: Arens,A.A, J.K. Loebbecke, 2000, Auditing: An integrated approach, New Jork, Prentice Hall

Chapter 4: Internal and external auditing

There are several types of auditors. The most common are certified public accounting firms and internal auditors.

4.1 Description of external auditing

CPA’s are responsible for auditing financial statements of the companies. There are some companies that are obliged to have audit of their financial statements. These are: publicly traded on the stock exchange companies, reasonably large companies and some non-profit organisations. The law regulations concerning this matter vary from country to country.

CPA firms are called external auditors, because they are engaged by companies to audit financial statements but they do not work for a company. An external auditor can be also an individual who is entitled to audit financial statements.

(Arens, 2000, p.13)

4.2 Description of internal auditing

On the contrary, internal auditors are employed by companies to audit for management. They often act as a part of an internal control system. These are auditors one person staff or whole departments that report to the management on the company’s performance. Their responsibilities are set by the management and they vary from one entity to another. They are also involved in compliance and operational auditing. Internal auditor is independent from the line functions in a company but he can not be independent from the company as external auditors are. Their main goal is to provide management with information required and helpful in the decision making process. (Arens, 2000, p.14)

The role of internal auditing is increasing nowadays as the companies become more complex and multinational. Internal auditors are necessary to control the operations and financial transactions also. They work for the company so their knowledge about it is significant, which helps in supervision and detecting errors. The work of internal auditors should be  controlled and evaluated under appropriate circumstances.

 (Arens, 2000, p.792)

Internal auditing functions as an independent-appraisal activity within an organization. The internal auditor must have a broad understanding of all aspects of a business. Not only must he be proficient in techniques of auditing, but he must understand principles of management and have a firm grasp of disciplines related to internal auditing such as accounting, economics, business law, finance and quantitative methods.

4.3 Comparison of external and internal auditing

The major difference between external and internal auditors is the lack of independence from the company in case of internal auditors.

Also, the objectives  of internal auditors are broader than the objectives of external auditors. It provides flexibility for internal auditors to meet company’s needs.

Another difference is whom each auditor is responsible to. Internal auditors report to the management, because they are employed by the company. External auditors serve to the external users of financial statements that are why their evaluation is considered to be more reliable for the entity’s outside environment.

(Arens, 2000, p.14)

Apart from differences there are also similarities between these two professions. CPA firms and internal auditors can audit the same financial statements and can be also involved in other kinds of auditing. They both must be competent as auditors and remain objective in performing their work. They follow similar methodology  in conducting audits, including planning and performing tests of controls.

External auditors rely on internal auditors as they reduce control risk and reduce need for substantive testing. Law regulations also permit sometimes the external auditors to use internal auditor for direct help on the auditing but first internal auditor’s competence and objectivity must be examined. (Arens, 2000, p.794)

Chapter 5: Inventory Audit

The inventory and warehousing cycle is specific because is closely related to other transaction  cycles like acquisition and payment cycle, payroll and personnel cycle or sales and collection cycle. The audit of inventory is often the most difficult, complex and time-consuming part of the audit, especially tests of the year-end inventory balance. (Arens, 2000, p. 646)

5.1 Inventory and warehousing cycle

It is better to divide inventory and warehousing cycle into two closely linked systems. One is involving the physical flow of goods and the other related costs. There are six functions that make up the inventory and warehousing system:

1. Process purchase orders
2. Receive of raw materials
3. Store raw materials
4. Process the goods
5. Store finished goods
6. Ship finished goods

The record used for inventory is a perpetual inventory master file. Separate perpetual records are kept for raw materials and finished goods. They include information concerning the units of inventory purchased, sold, in the manufacturing process and unit costs. (Arens, 2000, p. 648)

5.2 Audit of inventory cycle

When inventory is material to financial statements, the auditor must obtain appropriate audit evidence that proves the existence, completeness and condition of the inventory by attending the physical inventory count. The auditor must test the adequacy (structural tests) and effectiveness (functional tests) of the internal control system and perform assertion-based audit procedures. (Draft IDW 301, p.3)

The general purpose in auditing inventory cycle is to determine that raw materials, work-in-process, finished goods inventory and costs of goods sold are fairly stated in the financial statements. The audit of the inventory cycle can be divided into five parts:

1. Acquire and record raw materials, labour and overhead (it includes the first three functions, mentioned before, in the inventory cycle). This is examinated in details in the auditing of acquisition and payment cycle and payroll and personnel cycle.
2. Internally transfer assets and costs ( it includes following two functions in the inventory cycle). This is closely related to cost accounting records that are independent of other cycles and are examined in auditing of inventory and warehousing cycle.
3. Ship goods and record revenue and costs (it is connected with the last function in the inventory cycle). It is a part of sales and collection cycle auditing.
4. Physically observe inventory. It is unique as a part of inventory and warehousing cycle auditing.
5. Price and compile inventory. This part is also specific only for the inventory and warehousing cycle auditing. (Arens, 2000, p.650)

5.3 Tests of transactions for purchases for inventory.

The approach to test of transactions for purchases of goods or services for inventory combine the tests of the asset or expense acquired and the tests of related cash disbursement. This means that the canceled check and the supporting documents for the purchase, such as the vendor’s invoice, receiving report and purchase order, are examined concurrently. (Carmichael, 1996, p.402)

5.4 Audit of cost accounting

Cost accounting is connected with the second part of  the inventory audit. Cost accounting controls are those related to the physical inventory and the related costs from the point at which raw materials are requisitioned to the point at which the manufactured product is completed and transferred to storage. These controls consist of  physical controls over raw materials, work-in-process and finished goods inventory, and controls over the related costs.

The physical controls over the company’s assets are implemented in order to protect inventory form misuse and theft. There are a number of documents for authorizing the movement of inventory. Another cost accounting control is perpetual inventory master files that are maintained by persons who do not have access or custody over assets. Perpetual inventory master files provide a control over units on hand, that is necessary to start with production, the acquisition of additional materials or goods, they provide a record of the use of raw materials and the sale of finished goods.

In auditing cost accounting, there are four aspects important for an auditor to examine: physical controls over inventory, documents and records inventory, perpetual inventory master files and unit cost records.(Arens, 2000, p.651)

The internal controls over cost accounting vary significantly among organizations. The auditor should design adequate tests based on the understanding of the nature of the cost accounting records and the extent to which be relied on to reduce substantive tests. (Arens, 2000, p.653)

5.5 Shipping goods and recording revenue

This is examined in details in the sales and collection cycle. Most companies record sales as goods are shipped. At that moment the shipping document is prepared. Basing on shipping information, companies update the perpetual inventory master files. Then the company is billing customers, so auditor must make sure that each shipment was billed properly (once and for the proper amount). (Arens, 2000, p. 401)

5.6 Physical observation of inventory

The auditor should inspect the actual inventory listed in the inventory records and check the result of the physical count. The auditor should observe the count procedures and perform test counts. Only then he can determine whether the physical count was taken in accordance with the company’s instructions. ( Draft IDW 301, p.6)

There is a distinction between the observation of the physical inventory count and the responsibilities to conduct such count. The company is responsible for organizing the count and implementing some procedures in accordance with the law. Then it is responsible for recording the results of count. The auditor is supposed to observe count and examine the results of count. His opinion is expressed in final conclusions on the completeness and adequacy of the physical inventory in terms of the count. (Arens, 2000, p. 655)

5.7 Audit of pricing and compilation

It is necessary for an auditor to examine if physical counts or perpetual record quantities were properly priced and complied. There are inventory price tests to conduct in order to make sure that client’s unit prices are correct and inventory compilation tests that check if quantities are properly summarized. Then it is totally traced to the general ledger.

Internal controls on unit costs are conducted in order to make sure if the ending inventory is valued with the reasonable costs. The proper pricing of inventory is a long lasting part of the audit. In conducting price tests it is essential to check if the method is in accordance with obligatory accounting law regulations, the method was applicated from year to year and market value was considered in costs.. Method of verifying the pricing of inventory depends on whether items are purchased or produced. (Arens, 2000, p.659)

5.8 Combining the tests

All parts of the audit of inventory and warehousing cycle should be combined into one and this is the most difficult part of the audit in this case. The different tests that auditor has conducted, in order to evaluate if inventory and cost of goods sold are recorded properly and stated in accordance with reality, are related one to another.

The figure below shows the interrelations of the audit tests performed within different cycles and their final integration. (Arens, 2000, p.662)

Figure 2: Interrelations of different audit tests

Source: Arens,A.A, J.K. Loebbecke, 2000, Auditing: An integrated approach, New Jork, Prentice Hall

5.9 Conclusions

It is easy to notice that the inventory audit is a complex process mainly due to the difficulties connected with proving the existence of parts of inventory and their valuation. The cycle is special as many tests closely related with the cycle are examined as a part of the audit of other cycles.(Arens, 2000, p.663)

Chapter 6: Professional ethics of an auditor

6.1 Need for professional ethics

Ethics for the profession of an auditor is a very important matter as their performance is closely linked to public trust. In the recent year there were several cases of powerful companies going bankrupt because of  the forbidden accounting practices. Financial statements of those companies were examined by CPA firms but nothing was found. It is still a lot of controversy around such companies as Enron, Xerox or WorldCom.  These collapses were caused undoubtly by many factors but the role of  accounting abuses here is well-known. This kind of manipulation  with financial statements is called ‘creative accounting’ but is it ethical to applicate this kind of practices? The auditors that were evaluating the financial statements of these companies have committed a crime by ignoring or even suggesting some of the solutions.

6.2 Real life cases

Enron Corp.,  the US's biggest energy trader got collapsed. According to the experts this situation  was caused by so called bad credits and too expansive policy of the company. A year ago Enron's value was estimated at $80 billion. The company started to invest in different industry branches: oil processing, paper production, and even plane spare parts manufacturing. It didn't stop unprofitable investments although the financial indicators were getting worse. The Enron's directors and top officers approved a series of partnerships that moved debts off the company's balance sheet. In several cases, those partnerships enriched company officers but later produced huge losses for Enron.

At the moment Andersen – a CPA firm is on the trial for destroying documents from the Enron Corp. The company has merged with Ernst & Young,  humiliated with the Enron case. This failure has inspired directors and shareholders to demand more from their auditors. Some board panels are even calling quarterly meetings with their auditors, adding billable hours.

The SEC has acknowledged that is investigating two other CPA firms. KPMG has failed in detecting frauds at Xerox Corp. And Ernst & Young compromised its independence by selling software in a joint venture with an audit client. In the light of these cases there was even a proposition from Washington to implement a new law in USA requiring companies to change auditors every five years but the protests were too strong. (BusinessWeek, 2002, p.36-37)

 On the basis of these examples it could be possible to discuss professional ethics of the management or accountants of those companies but the most important case for this paper is a professional ethics of an auditor and CPA firms. Their relationships with users of financial statements are different than most other professions have with the users of services that they provide. Auditors are engaged and paid by the companies which financial statements are examined but the primary beneficiaries of the audit are statement users. That is why, it is so important that users regard auditors or CPA firms as competent and reliable. (Arens, 2000, p.81)

6.3 Meaning of ethics

‘Ethics can be defined as a set of moral principles and values’ (Arens, 2000, p.76). These are rules that every person considers to be the most important in his or her life. In general, ethical rules help in making decisions and choices where the options are not clear or where there is no absolute right or wrong answer. Everyone face the problems called ‘ethical dilemmas’ in which persons chooses an appropriate way of behavior. An example of an ethical dilemma in an auditors business life is when clients threats to look for a new auditor if an auditor doesn’t want to issue an unqualified opinion. (Arens, 2000, p.78)

Understanding the reasons why people act unethically can help in realizing how strong set of rules generally accepted by law and  considered in a society as proper ones, auditors should have to fulfill their responsibilities. People act unethically mainly because their personal ethical standards differ from the rest of the society. Sometimes their personal rules are the same but they chose to behave selfishly. Many unethical behavior is also caused by hidden financial desires, greed or simply by laziness. These can give a view on what kind of person an auditor should be. The reality shows often that it is hard to overcome these obstacles.(Arens, 2000, p.77)

6.4 Professional ethics of an auditor

In professional life, auditors must be able to examine critically situation where there is,  for instance, a conflict of loyalties and interests involving issues concerning his responsibilities. The professional ethics of an auditor is based on his personal moral rules but also on the Code of the Professional Conduct. There are several such Codes valid on an international or on a country level. Sometimes it happens that personal moral rules influence the auditors decisions and help in following the law regulations. Auditor as a professiolalists is expected to conduct himself in a moral way so that nothing can spoil opinion of the people about him. The same concerns the CPA firms; Their moral rules should be strictly followed by all employees. Many people consider a crime as more serious when it was committed by a professional. (Arens, 2000, p.80)

6.5 AICPA Code of Professional Conduct

The AICPA Code of Professional Conduct includes ethical rules that an auditor should follow in his or her work. The Code includes some general standards of ideal professional behavior, but also specific rules of conduct. According to the AICPA Code of Professional Conduct, there are six main ethical principles that an auditor should follow:

Article I. Responsibilities (Fulfill their responsibilities, exercising professional and moral judgments)

“In carrying out their responsibilities as professionals, members should
exercise sensitive professional and moral judgments in all their activities.”

Article II. The Public Interest (Act in a manner that serves the Public Interest)

“Members should accept the obligation to act in a way that will serve the public interest, honor the public trust, and demonstrate commitment to professionalism.”

Article III. Integrity (Perform responsibilities with the highest sense of Integrity)

“To maintain and broaden public confidence, members should perform
all professional responsibilities with the highest sense of integrity.”

Article IV. Objectivity and Independence (Should maintain Objectivity and Independence in Fact and Appearance)

“A member should maintain objectivity and be free of conflicts of
interest in discharging professional responsibilities. A member
in public practice should be independent in fact and appearance
when providing auditing and other attestation services.”

Article V. Due Care (Should exercise Due Care, observe technical and ethical standards, and improve competence and quality of services and do his/her best).

“A member should observe the profession's technical and ethical standards,
strive continually to improve competence and the quality of services, and
discharge professional responsibility to the best of the member's ability.”

Article VI. Scope and nature of Services (Should only provide the appropriate Scope and Nature of Services).

“A member in public practice should observe the Principles of the Code of Professional Conduct in determining the scope and nature of services to be provided.”

6.6 Conclusions

A detailed examination of the rules that an auditor should follow shows that they are applicable to almost any profession not just auditors. The Code indicates the proper behavior and how an auditor should fulfill his obligations but any law can predict all the situations that auditor has to face in the real professional life. In these situations of ethical dilemmas, the strong moral set of personal values helps to solve problems. Sometimes a detailed analysis can lead to the best decision in the particular case.(Cosserat, 2000, p. 70)

References

Books

Arens, A.A., J.K. Loebbecke, 2000, Auditing: an integrated approach, New York, Prentice Hall.

Carmichael, D.R., J.J. Willingham, C.A. Schaller, 1996, Auditing concepts and methods: a guide to current theory and practice, McGraw Hill.

Cosserat, G.W., 2000, Modern Auditing,  Chichester, Wiley.

Gray, I., S. Manson, 2000, London, Business press

Taylor, D.H., G.W. Glezer, 1997, Auditing: an assertion approach, New York, John Wiley & Sons

Internet

 – The American Institute of Certified Public Accountants

 – Draft IDW 301 Auditing Standard

 – Krajowa Izba Bieglych Rewidentow

Articles

McNamee, M., J. Weber,Blooded but Rich, Business Week, June 3, 2002