UBAF02144/UKAF 2124-AUDITNG & ASSURANCE SERVICES II

Tutorial 10- Internal Auditing

Review questions

Q1. Define Corporate Governance. Why do you think an effective internal audit
function is essential to good corporate governance?

Q2. How do internal auditors assist the board of directors of an organisation?

Q3. What are the differences between the independence of an internal auditor and that
of an independent auditor? How can an internal auditor be truly independent?

Q4. Define the meaning of economy, efficiency, and effectiveness in the performance
audit.

Q5. Describe the roles of internal audit department.

Q6. Identify the three major differences between financial and operational auditing.

Scenario / application questions

Question 1

During the management seminar that you attended recently, you heard the following
comments made by Datin Wong, the president of a large company:

“I do not quite understand what this whole army of internal auditors is doing in the
private sector. They are certainly useful in the public sector, where they must make sure
that a whole multitude of laws, regulations, and directives are followed to the letter. But
the situation is quite different in private business, where profit is an important source of
motivation.

After having given it considerable thought, I do not quite see what positive contribution a
group of internal auditors could make to our company or what management could expect
from this function. I do not see how internal auditing could contribute to improving the
quality of management in our company.

We already spend a fortune on the annual audit of our financial statements, and our
external auditors are very competent. Furthermore, quite opposite to internal auditors,
they are independent from management. In any event, the work done by our external
auditors gives us assurance that everything is well managed in our company and that we
are well protected against fraud. Otherwise, they would not be able to give an unqualified
opinion on our financial statements year after year.”

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Required
Comment on Datin Wong’s statement identifying the arguments that could convince her
of the usefulness of the internal audit function in a large company.

(Adapted from the Malaysian Association of Certified Public Accountants)

Question 2

You have been promoted to be the chief audit executive of a listed company in
Melbourne. The company is a major manufacturer and exporter of mid-range motor
vehicles and has suffered some financial set backs in recent years. You are about to hold
your first meeting with the chair of the audit committee to discuss your vision and plans
for the new internal audit department.

Explain the key matters to be discussed with the Chair of Audit Committee.

Question 3

Metra group’s activities comprise retailing of general merchandise and luxury goods. The
group has established an internal audit function for many years.

Employee turnover in the internal audit department has risen, with high performing
employees moving to other departments and less successful ones resigned from the
organisation. In view of this, the Managing director (MD) of Metra Group has suggested
that the group outsources its internal audit function to independent party. However, the
Chief Executive Officer (CEO) of the group is not in favour of the MD’s suggestion. The
CEO has instead, proposed to the board to cease the internal audit function on the
justification that internal audit does not make any positive contribution to the group’s
performance.

He (CEO) further argued that work performed by the external auditors give the top
management of Metra group assurance that everything is well managed within the group
and that the group is protected against fraud; as such it is not necessary to have an
internal audit function.

Required:
(i) Briefly discuss potential benefits to Metra Group to justify the suggestion made by
the MD to outsource the internal audit function. .
(ii) Identify arguments that could convince the CEO on the usefulness of the internal
audit function within the group as compared to external auditors.

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Question 4-Refer to Q 26-24 of Arens 3rd. Edition Page 792

Lajod Company has an internal audit department consisting of a manager and three staff
auditors. The manager of internal audits, in turn, reports to the corporate controller.
Copies of audit reports are routinely sent to the audit committee of the board of directors
as well as to the corporate controller and the individual responsible for the area or activity
being audited.

The manager of internal audits is aware that the external auditors have relied on the
internal audit function to a substantial degree in the past. However, in the recent months,
the external auditors have suggested there may be a problem related to the objectivity of
the internal audit function. This objectivity problem may result in more extensive testing
and analysis by the external auditors.

The external auditors are concerned about the amount of nonaudit work performed by the
internal audit department. The percentage of nonaudit work performed by the internal
auditors in recent years has increased to about 25% of their total hours worked. A sample
of the five recent nonaudit activities are as follows:

1. One of the internal auditors assisted in the preparation of policy statements on

internal control. These statements included such things as policies regarding
sensitive payments and standards of control for internal controls.

2. The bank statements of the corporation are reconciled each month as a regular
assignment for one of the internal auditors. The corporate controller believe this
strengthens internal controls because the internal auditor is not involved in the
receipt and disbursement of cash.

3. The internal auditors are asked to review the budget data in every area each year
for relevance and reasonableness before the budget is approved. In addition, an
internal auditor examines the variances each month, along with the associated
explanations. These variance analyses are prepared by the corporate controller’s
staff after consultation with the individuals involved.

4. One of the internal auditors has recently been involved in the design, installation
and initial operation of a new computer system. The auditor was primarily
concerned with the design and implementation of internal accounting controls and
the computer application controls for the new system. The auditor also conducted
the testing of the controls during the tests runs.

5. The internal auditors are often asked to make the accounting entries for complex
transactions before the transactions are recorded. The employees in the
accounting department are not adequately trained to handle such transactions. In
addition, this serves as a means of maintaining internal control over complex
transactions. The manager of internal audits has always made an effort to remain

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independent of the corporate controller’s office and believers that the internal
auditors are objective and independent on their audit and nonaudit activities.

Required:
a. Define objectivity as it relates to the internal audit function.
b. For each of the five situations outlined, explain whether the objectivity of Lajod
Company’s internal audit department has been materially impaired. Consider each
situation independently.
c. The manager of audits reports to the corporate controller.
(1) Does this reporting relationship result in a problem of objectivity? Explain
your answer.
(2) Would your answer to any of the five situations in requirement b have
changed if the manager of internal audits reported to the audit committee of
the board of directors? Explain your answer.

(CMA adapted)

Question 5-Refer to Q 26-28 of Arens 3rd. Edition Page 795

Superior Co. manufactures automobile parts for sale to the major U.S. automakers.
Superior’s internal audit staff is to review the internal controls over machinery and
equipment and make recommendations for improvements when appropriate. The internal
auditors obtained the following information during the assignment:
 Requests for purchase of machinery and equipment are normally initiated by the
supervisor in need of the asset. The supervisor discusses the proposed acquisition
with the plant manager. A purchase requisition is submitted to the purchasing
department when the plant manager is satisfied that the request is reasonable and
that there is a remaining balance in the plant’s share of the total corporate budget
for capital acquisition.
 Upon receiving a purchase requisition for machinery or equipment, the
purchasing department manager looks through the records for an appropriate
supplier. A formal purchase order is then completed and mailed. When the
machine or equipment is received, it is immediately sent to the user department
for installation. This allows the economic benefits from the acquisition to be
realized at the earliest possible date.
 The property, plant, and equipment ledger control accounts are supported by
computerized depreciation lapse schedules organized by year of acquisition.
These lapse schedules are used to compute depreciation as a unit for all assets of a
given type that are acquired in the same year. Standard rates, depreciation
methods, and salvage values are used for each major type of fixed assets. These
rates, methods, and salvage values were set 10 years ago during the company’s
initial year of operation.
 When machinery or equipment is retired, the plant manager notifies the
accounting department so that the appropriate entries can be made in the
accounting records.

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 There has been no reconciliation since the company began operations between the
accounting records and the machinery and equipment on hand.

Required:
Identify the internal control deficiencies and recommend improvements that the internal
audit staff of Superior Co. should include in its report regarding the internal controls over
fixed assets. Use the following format in preparing you answer:

DEFICIENCIES RECOMMENDATIONS
1. 1.