A SEMINAR ON
THE HISTORICAL BACKGROUND OF AUDITING
ABSTRACT
This paper aims to analyze the historical background, objectives and scope of examination of auditing and audit planning and supervision. It is found that auditing has evolved through a number of stages. In the mid 1800s to early 1900s, the audit practice was considered as “traditional conformance role of auditing”. However, for the past 30 years, the auditor has been playing an “enhancing role”. Today, auditors are expected not only to enhance the credibility of the financial statement, but also to provide value-added services. Nevertheless, following extensive reform in various countries as a result of the collapse of big corporations, it is expected that the role of auditors will converge. It is evident that the paradigm about auditing has shifted over the years and it is likely to continue shifting in the future.
OBJECTIVE OF THE PAPER
This paper aims to analyze the development of auditing over the years, with particular reference to the nature and objectives of auditing, the responsibilities of auditors and the audit techniques used. The reasons for such an analysis is to enable readers to gain an understanding of the audit development over the years. Secondly, it provides the evidences on auditing as a discipline that modifies its role over the years to meet the changing needs and expectations of society.
The word “audit” came from the Latin word audire, meaning “to hear”. According to Flint (1988), audit is a social phenomenon which serves no purpose or value except if its practical usefulness and its existence is wholly utilitarian. Flint (1988) further explains that the audit function has evolved in response to a perceived need of individuals or groups in society who seek information or reassurance about the conduct or performance of others in which they have an acknowledged and legitimate interest. Flint (1998) further argues that audit exists because interested individuals or groups are unable for one or more reasons to obtain for themselves the information or reassurance they require. Hence, an audit function can be observed as a means of social control because it serves as a mechanism to monitor conduct and performance, and to secure or enforce accountability. Mackenzie in the foreword to The Accountability and Audit of Governments made the following remark:
“Without audit, no control; and if there is no control, where is the seat of power?”
All in all, an audit function plays a critical role in maintaining the welfare and stability of the society.
Many auditors in the likes of Mascarenhas & Turley, 1990; Abdel-Qader, 2002; Porter, et al., 2005 concurred with Flint (1988) that the aim of an audit has always been a dynamic rather than a static one. Brown (1962) asserts that the objective and techniques of auditing have changed during the four hundred years of recognizable existence of auditing to suit the changing needs and expectations of society. It can be observed that the changes in needs and expectations of society are highly influenced by the factors contextual to the economic, political and sociological environment at a particular point of time. Therefore, the review of the historical development of auditing enables one to understand, analyze and interpret the evolution of auditing due to the change in expectations of the society.
Auditing as it exists today was established only in the later part of the nineteenth century, born out of the complexity of modern day business world. During the 18th century, industrial revolution brought in large scale production, steam power, improved facilities and better means of communication. This resulted in the origin of Joint stock form of organizations. Shareholders contribute capital of these companies but do not have control over the day to day working of the organization. The shareholders who have invested their money would naturally be interested in knowing the financial position of the company, to enable them to know this; the shareholders formed a body known as the board of directors who then present as account to them at the end of each financial year. Soon, a problem of believing that their funds have been honestly and prudently managed arose, this originated the need of an independent person who would check the accounts and report back to the shareholders on the accuracy of the accounts and the safety of their investment.
At this stage, it is important to have the concept of “audit” defined.
DEFINITION OF AUDIT
The Auditing Standard defined an audit as the independent examination of and an expression of opinion on the financial statement of an enterprise by an appointed auditor in pursuance of that appointment and in compliance with any relevant statutory obligation.
According to R. K. Mautz, auditing is concerned with the verification of accounting data, with determining the accuracy and reliability of accounting statements and reports.
Lawrence R. Dicksee, puts it this way “an audit is an examination of accounting records undertaken with a view to establishing whether they correctly and completely reflect the transactions to which they relate. In some instances, it may be necessary to ascertain whether the transactions themselves are supported by authority.”
It is clear from the above definitions that auditing is the systematic and scientific examination of the books of accounts and records of a business so as to enable the auditor to satisfy himself that the Balance Sheet and the Profit and Loss Account are properly drawn up so as to exhibit a true and fair view of the financial state of affairs of the business and profit or loss for the financial period. The Auditor have to go through various books and accounts and related evidence to satisfy himself about the accuracy and authenticity to report the financial health of the business.
THE EVOLUTION OF AUDITING PRACTICES
To facilitate the examination of the historical development of auditing, this review will be divided into the following five chronological periods:
(i) The period Prior to 1840;
(ii) The period 1840s to 1920s;
(iii) The period 1920s to 1960s;
(iv) The period 1960s to 1990s; and
(v) The period 1990s to present day.
THE PERIOD PRIOR TO 1840
Generally, the early historical development of auditing is not well documented (Lee, 1994). Auditing in the form of ancient checking activities was found in the ancient civilizations of China (Lee, 1986), Egypt and Greece (Boyd, 1905). The ancient checking activities found in Greece (around 350 B.C.) appear to be closest to the present-day auditing. During this period, every single public officer must account for everything given to them. Anyone against whom they prove embezzlement is convicted and fined by the court ten times the sum discovered stolen. Anyone, whom the court on [their]….evidence convicts of corruption, is also fined ten times the amount of bribe. If he is found guilty of administrative error, they assess the sum involved, and he is fined that amount provided in this case that he pays it within nine months; otherwise the fine is doubled. Similar kinds of checking activities were also found in the ancient Exchequer of England. When the Exchequer was established in England during the reign of Henry 1(1100-1135), special audit officers were appointed to make sure that the state revenue and expenditure transactions were properly accounted for (Gul, et al., 1994). The person who was responsible for the examinations of accounts was known as the “auditor”. The aim of such examination was to prevent fraudulent actions. Likewise, the existence of checking activities was found in the Italian City States. The merchants of Florence, Geneo and Venice used auditors to help them to verify the riches brought by captains of sailing-ships returning from the Old World and bound for the European Continent. Again, auditing in this period was concerned about detection of fraud. The audit found in the City of Pisa in 1394 was somehow similar to those found in the Italian City State. It was meant to test the accounts of government officials to determine whether or not defalcation had taken place (Brown, 1962). According to Porter, et al (2005), auditing had little commercial application prior to the industrial revolution. This is because industries during this period were mainly concerned with cottages and small mills which were individually owned and managed. Hence, there was no need for the business managers to report to owners on their management of resources. As a result, there is little use of auditing. During this period, a system of accounting known as charge and discharge principle were kept by the early Greek and Roman accounts. This principle enforced accounting for stewardship. It maintained a check on the honesty and accuracy of the stewards charged with some trust. The Greek considered accountability of official very important that every steward, agent or public official had to render account periodically by producing the two lists. The charge list consists of the opening balance of goods/monies due to the principal, plus the goods/monies received on his behalf during the period while the discharge list consists of expenses made on behalf of the principal, the balance represents the amount due to him at the end of the period. (Ngozi, B. N.& Okoye, E. I. 1998)
In a nutshell, in the period pre-1840, the auditing at the time was restricted to performing detailed verification of every transaction. The concept of testing or sampling was not part of the auditing procedure. The existence of internal control is also unknown. Fitzpatrick (1939) commented that the audit objective in the early period was primarily designed to verify the honesty of persons charged with fiscal responsibilities.
THE PERIOD 1840s TO 1920s
The practice of auditing did not become firmly established until the advent of the industrial revolution during the period 1840s-1920s in the UK (Gill & Cosserat, 1996, Ricchiute, 1989). According to Brown (1962), the large-scale operations that resulted from the industrial revolutions drove the corporate form of enterprise to the foreground. Large factories and machine-based production were established. As a result, a vast amount of capital is needed to facilitate this huge amount of capital expenditure. The emergence of a “middle class” during the industrial revolution period provided the funds for the establishment of large industrial and commercial undertakings. However, the share market during this period was unregulated and highly speculative. As a consequence, the rate of financial failure was high and liability was not limited. Innocent investors were liable for the debts of the business. In view of this environment, it was apparent that the growing number of small investors was in dire need of protection (Porter, et al, 2005). Hence, the time was ripe for the profession of auditing to emerge (Brown, 1962).
In response to the socio-developments in the UK during this period, the Joint Stock Companies Act was passed in 1844. The Joint Stock Companies Act stipulated that “Directors shall cause the Books of the Company to be balanced, and a full and fair Balance Sheet to be made up”. In addition, the Act provided the appointment of auditors to check the accounts of the company. However, the annual presentation of the balance sheet to the shareholders and the requirement of a statutory audit were only made compulsory in 1900 under the Companies Act 1862 (UK). According to Porter, et al (2005) the accountant particularly in the early years of this period, was normally the company manager and his duties were to ensure proper use of the funds entrusted to him. The auditors during this period were merely shareholders chosen by their fellow members. Brown (1962) claimed that the auditors during this period were required to perform complete checking of transactions and the preparation of correct accounts and financial statements. Little attention was paid to internal control of the company. Porter, et al (2005) commented that the duties of auditors during this period were influenced by the decisions of the courts. For example, the verdicts from the case of London and General Bank (1985) and Kingston Cotton Mill (1896) reinforced that the audit objective was detection of fraud and errors. These cases in turn established the general standard of work expected of auditors. Likewise, as noted in the auditing book of Lawrence R Dicksee (1892 cited in Leung, et al, 2004, p. 7): A Practical Manual for Auditors, the objectives of auditing were:
(i) the detection of fraud;
(ii) the detection of technical errors, and
(iii) the detection of errors of principles. It can be
Concluded that the role of auditors during the period of 1840s-1920s was mainly on fraud detection and the proper portrayal of the company’s solvency (or insolvency) in the balance sheet.
THE PERIOD 1920s TO 1960s
The growth of the US economy in the 1920s-1960s had caused a shift of auditing development from the UK to the USA. In the years of recovery following the 1929 Wall Street Crash and ensuing depression, investment in business entities grew rapidly. Meanwhile, the advancement of the securities markets and credit-granting institutions had also facilitated the development of the capital market in this period. As companies grew in size, the separation of the ownership and management functions became more evident. Hence to ensure that funds continued to flow from investors to companies, and the financial markets function smoothly, there is a need to convince the participants in the financial markets that the company’s financial statement provided a true and fair portrayal of the relevant company’s financial position and performance (Porter, 2005). In view of the economic condition, the audit function was mainly to provide credibility to the financial statements prepared by company managers for their shareholders. Consensus were generally achieved that the primary objective of an audit function is adding credibility to the financial statement rather than on the detection of fraud and errors. Such a change in audit objective is evidenced in successive edition of Montgomery’s Auditing text issued during this period which stated “An incidental, but nevertheless important, objective of an audit is detection of fraud.” “Primary responsibility…for the control and discovery of irregularities necessarily lies with management.” Hence, it can be witnessed that the shift of the focus of an audit function from preventing and detecting fraud and error towards assessing the truth and fairness of the companies’ financial statements began at this period. The concept of materiality (Queenan, 1946) and sampling techniques (Brown, 1962) were used in auditing during this period. The development of material concept and sampling technique was due to the voluminous transactions involved in the conduct of business by large corporations operating in widespread locations. It is no longer practical for auditors to verify all the transactions. Consequently, sampling and the development of judgment of materiality were essential. The use of sampling technique during this period can be proven from the following statement “… it is not necessary to make a detailed examination of every entry, footing, and posting during the period in order to get the substance of the value which resulted from an audit”.
Corresponding to the use of sampling techniques, auditors need to rely on internal control of the company to facilitate the use of such research approach. The reliance on internal control during this period can be witnessed from the following statement found in page 240 of Accountants Digest in March 1936: The first step to take when planning an audit by test methods consists of a thorough investigation of the system on which the books are kept…It is not the auditor’s sole duty to see that the internal check is carried out but to ascertain how much it can be relied upon to supplement his investigation.
The fundamental principles of auditing during this period were influenced by some major auditing cases such as the case of McKesson and Robbins (1938). The verdict of this case had resulted in the emphasis of physical observation of assets such as cash and stock, and the use of external evidence. In addition, the Royal Mail case highlighted the need of audit for the profit and loss statements. However, the audit of profit and loss account was only made mandatory with the enactment of Securities and Exchange Commission Act 1934 in the USA and Companies Act 1948 in the UK. In short, the social-economic condition in the period had highly influenced the development of auditing. As highlighted by Porter, et al (2005) the major characteristics of the audit approach during this period, among others, included:
(i) reliance on internal control of the company and sampling techniques were used;
(ii) audit evidence was gathered through both internal and external source;
(iii) emphasis on the truth and fairness of financial statements;
(iv) gradually shifted to the audit of Profit and Loss Statement but Balance Sheet remained important; and
(v) physical observation of external and other evidence outside the “book of account”.
THE PERIOD 1960s to 1990s
The world economy continued to grow in the 1960s-1990s. This period marked an important development in technological advancement and the size and complexity of the companies. Auditors in the 1970s played an important role in enhancing the credibility of financial information and furthering the operations of an effective capital market. Similar description on the auditors’ role was found in The New York Times on 6 April 1975 (Leung, et al., 2004, p. 10) that the duties of auditors, among others, were to affirm the truthfulness of financial statements and to ensure that financial statements were fairly presented. Hence, the role of auditors with regard to the audit of financial statement generally remained the same as per the previous period. Despite the overall audit objectives remaining similar, Davies (1996) opines that auditing had undergone some critical developments in this period. In the earlier part of this period, a change in audit approach can be observed from “verifying transaction in the books” to “relying on system”. Such a change was due to the increase in the number of transactions which resulted from the continued growth in size and complexity of companies where it is unlike for auditors to play the role of verifying transactions. As a result, auditors in this period had placed much higher reliance on companies’ internal control in their audit procedures. Furthermore, auditors were required to ascertain and document the accounting system with particular consideration to information flows and identification of internal controls. When internal control of the company was effective, auditors reduced the level of detailed substance testing.
In the early 1980 there was a readjustment in auditors’ approaches where the assessment of internal control systems was found to be an expensive process and so auditors began to cut back their systems work and make greater use of analytical procedures (Salehi, 2007). An extension of this was the development during the mid-1980s of risk-based auditing (Turley & Cooper, 1991). Risk-based auditing is an audit approach where an auditor will focus on those areas which are more likely to contain errors. To adopt the use of risk-based auditing, auditors are required to gain a thorough understanding of their audit clients in terms of the organization, key personnel, policies, and their industries (Porter, et al., 2005) Hence, the use of risk-based auditing had placed strong emphasis on examining audit evidence derived from a wide variety of sources, i.e. both internal and external information for the audit client.
According to Porter, et al (2005), most of the companies in this period had introduced computer systems to process their financial and other data, and to perform, monitor and control many of their operational and administrative processes. Similarly, auditors placed heavy reliance on the advanced computing auditing tool to facilitate their audit procedures. In addition to the auditing of financial statement, auditors at the same time were providing advisory services to the audit clients. Leung, et al (2004) made the following comments in connection with the role of auditors in providing such services: There was a surge of one-stop shows such as multidisciplinary practices and the development of holistic audit strategies which provided an extensive range of non-audit services performed for audit client. Accounting and auditing during this period has become an industry with strong competition among firms, a blurring of relationship with clients, an apparent failure to exercise due diligence by some. Porter, et al (2005) opined that the provision of advisory services emerged as a secondary audit objective in the period of 1960s-1990s. Since then, the role of auditors has always been highly associated with such advisory services.
THE PERIOD 1990s TO THE PRESENT DAY
The auditing profession witnessed substantial and rapid change since 1990s as a result of the accelerating growth at the world economies. It can be observed that auditing in the present day has expanded beyond the basic financial statement attest function. According to Porter et al (2005), present-day auditing has developed into new processes that build on a business risk perspective of their clients. The business risk approach rests on the notion that a broad range of the client’s business risks are relevant to the audit. Advocates of the business risk approach opined that many business risks, if not controlled, will eventually affect the financial statement. Furthermore by understanding the full range of risks in businesses, the auditor will be in a better position to identify matters of significance and relevance to the audit profession on a timely basis. Since the early 1990s, the audit profession began to take increased responsibility to detect and report fraud and to assess, and report more explicitly, doubts about an auditee’s ability to continue in conformance with society’s and regulators’ increasing concern about corporate governance matters. Adoption of the business risk approach in turn enhances auditor’s ability to fulfill these responsibilities (Porter, et al., 2005). Presently, the ultimate objective of auditing is to lend credibility to financial and non-financial information provided by management in annual reports; however, audit firms have been largely providing consultancy services to businesses. By 2000, consulting revenues exceeded auditing revenues at all the major audit firms in the USA. Regulators of the auditing profession and the investing public began to doubt whether audit firms could remain independent on audit issues when the firms were so dependent on consulting revenues. The quality of audits is being placed under scrutiny after a series of financial scandals of public companies such as Sunbeam, Waste Management, Xeror, Adelphia, Enron and WorldCom. The collapses of these giant corporations had brought about a crisis of confidence in the work of auditors (Boynton & Johnson, 2006). As a consequence of the high level of litigation and criticism against the auditors, nearly all large accounting firms split their consulting arms into separate companies and made announcements on their more stringent rules and measures to ensure better independence and audit quality. In addition, a spate of radical reforms was undertaken in various countries, by the accounting bodies, governments, stock exchange commissions and academics to strengthen the audit practice (Leung, et al., 2004). Some of the key reform activities include:
(1) The Sarbanes-Oxley Act (The US) In response to the fall of Enron the Sarbanes-Oxley Act was implemented. It outlines the rules on auditor independence, for example, the control of audit quality, and the rotation of audit partners as well as the prohibition of conflict-of-interest situation. Furthermore, the act also requires auditors to report to the audit committee on those significant matters. The Public Company Accounting Oversight Board which oversees audit firms and their procedures and the enforcement of accounting standards is also established as a result of this act. The Sarbanes-Oxley extended the duties of auditor to audit the adequacy of internal controls over financial reporting. This is in view of the fact that a number of commissions recognized the importance of internal control in preventing financial statement misstatement.
(2) Ramsay report (Australia) As a result of the collapse of HIH Insurance Ltd, the Australian Government Commission engaged professor Ian Ramsay to investigate the issue of auditor independence. It was recommended that auditor independence can be improved through the following ways: Include a statement in the Corporations Act that auditors are to be independent; Require auditors to declare to the Board of Directors that their independence is maintained; Prohibit special relationships between the auditor and client; Establish an auditor independence supervisory board; Establish an audit committee to oversee the issue of non-audit services, audit fees, scope disagreements and auditor-client relationships.
Although the overall audit objectives in the present period remained the same, i.e. lending credibility to the financial statement, critical changes have been made to the audit practice as a result of the extensive reform in various countries. Leung, et al (2004, p. 24) is of the opinion that such reform has implicated the auditing profession in the following ways: “
(i) The role of auditors is expected to converge: refocusing on the public interest, redefining audit relationship, ensuring integrity of financial reports, separation of non-audit function and other advisory services;
(ii) (ii) The audit methods revert to basics i.e. risk attention, fraud awareness, objectivity and independence, and
(iii) (iii) increase attention on the needs of financial statement users”.
THE RISE OF INTERNAL AUDIT
The double-entry bookkeeping system invented in the 13th century provided the means for those engaged in commerce to control transactions with suppliers and customers, and check the work of employees. Historical records suggest that internal auditors were being utilized prior to the 15th century. These auditors, employed by kings or merchants, were charged with detecting or preventing theft, fraud, and other improprieties. Control techniques such as separation of duties, independent verification, and questioning (i.e. "auditing") to detect and prevent irregularities are thought to have originated during that time. Thus, control assessment and fraud detection have become known as the "roots" of internal auditing.
As industry and commerce evolved, so did control methods and auditing techniques. These methods migrated to the United States from England during the industrial revolution. Managerial control through auditing continued to gain favor up to and through the 20th century. Many events contributed.
The economy of the United States was growing rapidly after World War I and required better techniques for planning, directing, and evaluating business activities. Unfortunately, the growth was accompanied by a rise in price-fixing, interlocking directorates, stock manipulations, and false statements of business performance. Regulatory actions followed and auditing was used as a means to confirm that laws were being followed. The Federal Trade Commission (FTC) was created in 1914. The Great Depression and the 1930s brought more regulatory action for publicly traded securities. The Securities Act of 1933, the Securities and Exchange Act of 1934, the Public Utilities Holding Company Act of 1935, and the Investment Company Act of 1940 were enacted by the United States Congress.
As the need for auditing grew, corporations realized that they could no longer rely solely on external auditors from public accounting firms. Corporations began hiring auditors as their own employees to verify financial transactions and test compliance with accounting controls. Many of these internal auditors were hired from external auditing firms. They brought to the companies that hired them auditing methods used by public accountants with a financial statement focus. These internal auditors concentrated on financial auditing. Management viewed these internal auditors as a means to reduce external audit fees while maintaining the same level of financial audit coverage. Within some organizations this image of internal auditing still persists.
Internal auditing started to emerge as a function distinctly different from external auditing about the middle of the 20th century. Then, a significant event brought internal auditing to the forefront—the Foreign Corrupt Practices Act of 1977. The Act was the government's response to outcries as news of corporate wrong-doings increased. The Act was passed to prevent secret funds and bribery. It specifically prohibited offering of bribes to foreign officials. It required organizations to maintain adequate systems of internal control and maintain complete and accurate financial records. While the Act did not specifically call for an internal auditing function, internal auditors were poised and ready to help management fulfill the requirements of this Act. Testing and evaluation of internal controls within companies increased significantly. The role of internal auditors was viewed with new importance.
In the mid-to-late 1980s there were a number of large business failures and financial statement frauds. On several occasions external auditing firms failed to detect those frauds. The issues of fraudulent financial reporting were examined by a group of private sector organizations which included the American Institute of Certified Public Accounts (AICPA), the American Accounting Association (AAA), the Financial Executives Institute (FEI), the Institute of Internal Auditors (IIA), and the National Association of Accountants (NAA). This group of organizations, known as the Treadway Commission, issued its final recommendations in 1987. Several recommendations of the Treadway Commission were of great significance to internal auditors. Among other recommendations, the Commission's report directs companies to maintain adequate internal control systems, to establish effective and objective internal audit functions staffed with adequate qualified personnel, and to coordinate internal auditing with the external audit of the financial reports. The Commission's report also directed internal auditors to consider whether their findings of a non-financial nature could impact the financial statements. The Treadway Commission also directed its sponsoring organizations to develop guidance on internal control. That sponsoring group did so, issuing its report Internal Control — Integrated Framework in 1992, which again emphasized the importance of internal controls in organizations.
The evolution of internal auditing tracks changing business practices and concepts of internal control. At the most basic level, internal controls are individual preventive, detective, corrective, or directive actions that keep the operations functioning as intended. Basic controls, when aggregated, create whole networks and systems of control procedures, which are known as the organization's overall system of internal control. During the 1990s, business process "reengineering" and downsizing, removed layers of management and flattened organizational hierarchies. Traditional controls were loosened or dismantled to improve efficiency and lower costs. In response, internal auditing's control orientation moved away from evaluating individual process controls toward assessing the overall control environment—integrated control frameworks, corporate governance, and the ethical climate—within the organization. Internal auditors increased their use of risk assessments and aligned their activities with broader organizational goals to deploy their own scarce audit resources. Internal auditing's focus shifted to risk prevention and to promoting change. Even so, control assessment and fraud detection, the "roots" of internal auditing, still retained a place in the internal audit function.
INTERNAL AUDITING VS. EXTERNAL AUDITING
The industrial engineer studies methods of performing work, suggests improvements, designs and installs work systems, and evaluates results. Internal auditors do utilize some of the analytical techniques belonging to industrial engineers, but do not focus on them. Further, internal auditors do not design and install systems.
Internal auditors and external auditors both audit, but have different objectives. Internal auditors generally consider operations a whole relative to objectives. External auditors focus primarily on financial systems that have a direct, significant effect on the amounts reported in financial statements. Internal auditors consider even small amounts of fraud, waste, and abuse as symptoms of underlying issues. The external auditor considers just what materially affects the financial statements since that is the nature of their engagement. Sawyer's Internal Auditing summarizes the differences in the following way.
Management controls over financial activities have been greatly strengthened throughout the years. The same cannot always be said of controls elsewhere in the enterprise. Embezzlement can hurt a corporation; the poor management of resources can bankrupt it. Therein lies the basic difference between external auditing and modern internal auditing; the first is narrowly focused and the second is comprehensive in scope. True, the external auditor performs services for management and submits letters to management, which recommend improvement in systems and controls. By and large, however, these are financially oriented. Also, the external auditor's occasional sally into nonfinancial operations may not benefit from the same depth of understanding as does the resident internal auditor, who is intimately familiar with the organization's systems, people, and objectives.
"OUTSOURCING" OR "CO-SOURCING" THE INTERNAL AUDIT FUNCTION
The previous comparison of internal auditing to external auditing considers only the external auditors' traditional role of attesting to financial statements. During the 1990s a number of the large professional service firms (the "Big 5" public accounting firms) began establishing divisions offering internal auditing services in additional to tax, financial planning, actuarial, external auditing, and management consulting. New firms also emerged offering internal auditing services but not attestation (external audits) of financial statements. Predictably, the arrival of "outside" consultants ready to do "internal" audits caused a flurry of debate about independence, objectivity, depth of organizational knowledge, operational effectiveness, and long run costs to the organization. Regardless, the trend continued throughout the rest of the decade. Initial protests gave way to acknowledgment that non-employees can indeed perform internal audits. Orderly analyses of outsourcing's pros and cons followed. "Co-sourcing" (using outsiders for selected projects) became a useful compromise. That option provided access to an outside firm's resources while retaining a knowledgeable core of internal auditors to direct and manage co-sourced projects.
However, perceptions of impaired independence continued when public accounting firms providing opinions on financial statements also staffed the internal auditing function. In 1998, the American Institute of Certified Public Accounts (AICPA) decided that professionals from the same CPA firm could serve as external auditors of the financial statements and still perform internal auditing functions (called "extended services") without impairing independence if certain conditions were met. The AICPA required that outside professionals not act as employees and not assume ongoing control or other functions. It required management to retain responsibility for internal audit scope, planning, and risk assessments and to designate a competent executive to retain responsibility for the overall internal audit function. In New Zealand and several European countries, external auditors of financial statements in public sector companies may not provide internal audit services to the same company.
TYPES OF AUDITS
Various types of audits are used to achieve particular objectives. The types of audits briefly described below illustrate a few approaches internal auditing may take. The examples are not all inclusive.
OPERATIONAL AUDIT.
An operational audit is a systematic review and evaluation of an organizational unit to determine whether it is functioning effectively and efficiently, whether it is accomplishing established objectives and goals, and whether it is utilizing all of its resources appropriately. Resources in this context include funds, personnel, property, equipment, materials, information, intellectual property, or space. Operational audits often include evaluations of the work flow and propriety of performance measurements. These audits are tailored to fit the nature and objectives of the operations being reviewed.
PROGRAM AUDIT.
A program audit evaluates whether the stated goals or objectives for a project or initiative have been achieved. It may include an appraisal of whether an alternative approach can achieve the desired results at a lower cost. These types of audits are also called performance audits or management audits.
FRAUD AUDIT.
A fraud audit investigates whether the organization has suffered through misappropriation of assets, manipulation of data, omission of information, or illegal acts. It assumes that deceptions were intentional.
ETHICAL BUSINESS PRACTICES AUDIT.
An ethical business practices audit determines the extent to which the organization, management, and employees support established codes of conduct, policies, and standards of ethical practices. Topics that may fall within the scope of such audits include procurement policies, conflicts of interest, gifts and gratuities, entertainment, political lobbying, patents, copyrights, and licenses (including software use), or fair trade practices
COMPLIANCE AUDIT.
A compliance audit determines whether a process or transaction is or is not following applicable rules. Such rules can originate internally as corporate bylaws, policies, and procedures or externally as laws and regulations. Characteristic of compliance audits are the yes/no aspects of the evaluation. For each process or transaction examined, the auditor must ultimately decide whether it complies with the rule or not. Reaching that conclusion is not necessarily simple in domains governed by complex regulations (e.g. occupational health and safety, environmental, federal grants and contracts, employee pensions and benefits, or federal tax). Compliance auditors and attorneys specializing in these fields may be engaged to assist with evaluations if such specialists are not part of the internal audit staff.
SYSTEMS DEVELOPMENT AND LIFE CYCLE REVIEW
A systems development and life cycle review is an information systems audit conducted in partnership with operating personnel who are implementing a new information system. The objective is to appraise and independently test the system at various stages throughout the design, development, and installation. The approach intends to identify issues and correct problems early because modifications made during developmental stages are less costly. and some problems can be avoided altogether. The concern about this type of audit is that the internal auditor could lose objectivity through extended participation in the system design and installation.
CONTROL SELF-ASSESSMENT AUDIT.
A control self-assessment audit enlists management to share audit responsibility by evaluating and reporting on the state of controls and levels of risks under their supervision. Internal auditors provide training and act as facilitators. In effect this become a problem solving partnership and can be a cost-effective. Its inherent risk is that management's self-evaluation may be biased. Although, the internal auditor can retain the right to independently verify any reported conclusions.
FINANCIAL AUDIT.
A financial audit is an examination of the financial planning and reporting process, the conduct of financial operations, the reliability and integrity of financial records, and the preparation of financial statements. Such a review includes an appraisal of the system of internal controls related to financial functions.
SCOPE OF EXAMINATION
The scope of a statutory audit us required by legislature. The auditor has right to all information and explanation, he may require and has access to books of account. The auditor report is also guided by legislature. While the extent of examination to be carried out in the private audit can be limited by the person and persons who appointed the auditor. It is usually determined by the terms of appointment. Some documents or pieces of information could be withheld from the auditor as the contract could exclude any aspect of the account.
AUDIT PLANNING AND SUPERVISION
The first standard of field work requires that "the work is to be adequately planned and assistants, if any, are to be properly supervised." This section provides guidance to the independent auditor conducting an audit in accordance with generally accepted auditing standards on the considerations and procedures applicable to planning and supervision, including preparing an audit program, obtaining knowledge of the entity's business, and dealing with differences of opinion among firm personnel. Planning and supervision continue throughout the audit, and the related procedures frequently overlap.
The auditor with final responsibility for the audit may delegate portions of the planning and supervision of the audit to other firm personnel. For purposes of this section, (a) firm personnel other than the auditor with final responsibility for the audit are referred to as assistants and (b) the term auditor refers to either the auditor with final responsibility for the audit or assistants.
Audit planning involves developing an overall strategy for the expected conduct and scope of the audit. The nature, extent, and timing of planning vary with the size and complexity of the entity, experience with the entity, and knowledge of the entity's business. In planning the audit, the auditor should consider, among other matters:
a. Matters relating to the entity's business and the industry in which it operates (see paragraph .07).
b. The entity's accounting policies and procedures.
c. The methods used by the entity to process significant accounting information (see paragraph .09), including the use of service organizations, such as outside service centers.
d. Planned assessed level of control risk. (See section 319.)
e. Preliminary judgment about materiality levels for audit purposes.
f. Financial statement items likely to require adjustment.
g. Conditions that may require extension or modification of audit tests, such as the risk of material error or fraud or the existence of related party transactions.
h. The nature of reports expected to be rendered (for example, a report on consolidated or consolidating financial statements, reports on financial statements filed with the SEC, or special reports such as those on compliance with contractual provisions).
Procedures that an auditor may consider in planning the audit usually involve review of his records relating to the entity and discussion with other firm personnel and personnel of the entity. Examples of those procedures include:
a. Reviewing correspondence files, prior year's working papers, permanent files, financial statements, and auditor's reports.
