chapter
16
Auditing
Lonni Steven Wilson, Medaille College
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 audit
Audit 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?