Operations Auditing

Definition
An Operational Audit is a future-oriented, independent and systematic evaluation, often
performed by the internal auditor, for the purpose of assisting management in improving
organizational profitability and in the attainment of organizational objectives.

What is Operational Auditing?

● It uses logical audit techniques with a management perspective and applying them to
organizational objectives, operations, controls, communications, and information systems.
● It is concerned with the whom, what, when, where, why and how of running an efficient and
effective operations than just accounting and financial aspects of the business function.
● It is undergoing a transformation from a very broadly defined “audit of unit activities,
systems, and controls within an enterprise to reach economic, efficiency, effectiveness, or
other-related objectives” to a highly focused assessment of organization risk, capability and
performance.

Define the Objective – Why was the Auditor Called?

● New laws, regulations
● High costs
● Low revenues
● Operational inefficiencies, e.g. wastages/losses
● Unfavorable operational results
● Complaints due to poor service/product

Objectives of Operational Auditing

● Assist management in improving organizational profitability and in the attainment of
organizational objectives
● Determine whether a division, project or undertaking functions economically, efficiently and
effectively

Effectiveness versus Efficiency; Economy

Effectiveness refers to an entity’s or a unit of an entity’s success in actually achieving its goals
and objectives. Moreover, the measure of effectiveness includes an evaluation of compliance
with operational governance and infrastructure policies and procedures and the adequacy of
them.

Example of an operational audit for effectiveness: “To assess whether a governmental agency has
met its assigned objective of achieving elevator safety in a city”
Before the operational auditor can reach a conclusion about the agency’s effectiveness, criteria
for elevator safety must be set. For example, is the objective to see that all elevators in the city

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are inspected at least once a year? Is the objective to ensure that no fatalities occurred as a result
of elevator breakdowns or that no breakdowns occurred?

Efficiency refers to how well an entity uses its resources to achieve its goals. It is also described
as reducing cost without reducing effectiveness. For example, if two different production
processes manufacture a product of identical quality, the process with the lower cost is
considered more efficient.

The following are several types of inefficiencies that commonly occur and often are uncovered
through operational auditing.

Types of Inefficiency Example

• Work is done that serves no purpose . * Copies of vendors’ invoices and

receiving reports are sent to the
production department where they
are filed without ever being used.

• Raw materials are not available for * An entire assembly line must be
production when needed. shut down because necessary
materials were not ordered.

• Acquisition of goods and services is * Bids for purchases of materials are

excessively costly. not required.

• There are too many employees. * The office work could be done
effectively with one less adminis-
trative assistant.

• There is duplication of effort by *

Identical production records are
employees. kept by both the accounting and
production departments because
they are unaware of each other’s
activities.
______________________________________________________________________________

Economy refers to an entity’s success in maximizing the use of its limited resources to achieve
its goals and objectives.

Scope of Operational Audit

The auditors must determine specifically which policies and procedures are to be appraised and
how they relate to the specific objectives of the organization.

1. Economy and efficiency audits which include determining (a) whether the entity is
acquiring, protecting, and using its resources (such as personnel, property, and space)
economically and efficiently, (b) the causes of inefficiencies or uneconomical practices, and (c)
whether the entity has complied with laws and regulations concerning matters of economy
and efficiency.

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2. Program audits include determining (a) the extent to which the desired results or benefits
established by the legislature or other authorizing body are being achieved, (b) the
effectiveness of organizations, programs, activities, or functions, and (c) whether the agency
has complied with laws and regulations applicable to the program.
3. Compliance audit includes testing and reporting on whether an organization has complied
with the requirements of various laws, regulations and agreements.

Distinction Between Operational Auditing (OA) and Financial Auditing (FA)

A. Purpose of the Audit

o FA emphasizes whether historical information was correctly recorded whereas
OA emphasizes effectiveness, efficiency, and economy.
o FA is past-oriented whereas OA is concerned with operating performance for the
future. OA for example may evaluate whether a type of new material is being
purchased at the lowest cost to save money or future raw material purchases.

B. Nature and Distribution of the Report

o For FA, report typically goes to many users of financial statement, such as
stockholders and bankers; whereas OA reports are intended primarily for
management.
o Wording in FA reports is well-defined because of the widespread distribution of
the report.
o OA reports vary considerably from audit to audit of the diverse nature of audits
for efficiency and effectiveness.

C. Inclusion of Non-financial Areas

o OA covers any aspect of efficiency and effectiveness in an organization and can
therefore involve a wide variety of activities.
o FA is limited to matters that directly affect the fairness of financial statement
presentation.

Types of Operational Audits

There are three broad categories of operational audits: functional, organizational, and special
assignments. In each case, part of the audit is likely to concern evaluating internal controls for
efficiency and effectiveness.

1. Functional
As the name implies, a functional audit deals with one or more functions in an organization.
It could concern, for example, the payroll function for a division or for the company as a
whole.

Functions are a means of categorizing the activities of a business, such as the billing
function or production function. There are many different ways to categorize and subdivide
functions. For example, there is an accounting function, but there also cash disbursement,
cash receipt, and payroll disbursement functions. There is a payroll function, but there are
also hiring, timekeeping, and payroll disbursement functions.

A functional audit has the advantage of permitting specialization by auditors. Certain

auditors can develop considerable expertise in an area, such as production engineering.
They can more efficiently spend all their time auditing in that area. A disadvantage of

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 functional auditing is the failure to evaluate interrelated functions. The production
engineering function interacts with manufacturing and other functions in an organization.

2. Organizational
An operational audit of an organization deals with an entire organizational unit such as a
department, branch, or subsidiary. The emphasis in an organizational audit is on how
efficiently and effectively functions interact. The plan of organization and the methods to
coordinate activities are especially important in this type of audit.

3. Special Assignments
Special operational auditing assignments arise at the request of management. There are a
wide variety of such audits. Examples include determining the cause of an ineffective
computerized system, investigating the possibility of fraud in a division, and making
recommendations for reducing the cost of a manufactured product.

Who Performs Operational Audit?

Internal Auditor
Among the activities of the internal auditor that can aptly be construed as part of operations
audit are:
• Reviewing the reliability and integrity of financial and operating information and the
means used to identity, measure, classify, and report such information.
• Reviewing the internal control structure established to ensure compliance with those
policies, plans, procedures, laws and regulations which could have significant impact on
operations and reports and should determine whether the organization is in compliance.
• Reviewing the means of safeguarding assets and, as appropriate, verify the existence of
such assets.
• Appraising the economy and efficiency with which resources are employed.
• Reviewing operations or programs to ascertain whether results are consistent with
established objectives and goals and whether the operations or programs are being
carried out as planned.

Internal auditors are in such a unique position to perform operational audits that some people
use internal auditing and operational auditing interchangeably. It is, however, inappropriate to
conclude that all operational auditing is done by internal auditors or that internal auditors do
only operational auditing. Many internal audit departments do both operational and financial
audits. Often, they are done simultaneously. The internal auditors have an advantage in
performing operational audit because they have already developed considerable knowledge
about the company and its business, which is essential to effective operational auditing.

To maximize their effectiveness, the internal audit department should report to the board of
directors or president. Internal auditors should also have access to and ongoing
communications with audit committee of the board of directors. This organizational structure
helps internal auditors remain independent. For example, if internal auditors report to the
controller, it is difficult for the internal auditor to evaluate independently and make
recommendations to senior management about inefficiencies in the controller’s operations.

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Government Auditor
Most of the government auditors are concerned with both financial and operational audits, also
referred to as performance audits.

Performance audits include the following:

• Economy and efficiency audits. These have as their purpose determining (1) whether an
entity is acquiring, protecting and using its resources economically and efficiently; (2)
the causes of inefficiencies or uneconomical practices; and (3) whether the entity has
complied with laws and regulations concerning matters of economy and efficiency.

• Program audits. These have as their purpose determining (1) the extent to which the
desired results or benefits established by the legislature or other authorizing body are
being achieved; (2) the effectiveness of organizations, programs, activities or functions;
and (3) whether the entity has complied with laws and regulations applicable to the
program.

The first two objectives of each of these types of performance audits are clearly operational in
nature. The final objective in each is compliance in nature.

CPA Firms
The background knowledge about a client’s business that an external auditor must obtain in
doing an audit often provides useful information for giving operational recommendations. For
example, suppose the auditor determined that inventory turnover for a client slowed
considerably during the current year. The auditor is likely to determine the cause of the
reduction to evaluate the possibility of obsolete inventory that would misstate the financial
statements. In determining the cause of the reduced inventory turnover, the auditor may
identify operational causes, such as ineffective inventory acquisition policies, that can be
brought to the attention of management. An auditor who has a broad business background and
experience with similar businesses is more likely to be effective at providing clients with
relevant operational recommendations than a person who lacks those qualities.

It is also common for a client to engage a CPA firm to do operational auditing for one or more
specific part of its business. Usually, such an engagement would occur only if the company
does not have internal audit staff or the internal audit staff lacks expertise in a certain area. In
most cases, a management consulting staff of the CPA firm, rather than the auditing staff,
performs these services. For example, a company can ask the CPA firm to evaluate the
efficiency and effectiveness of its computer systems.

Important Qualifications of Operation Auditors

Who the auditor reports to is important to ensure that investigation and recommendation are
made without bias. Independence is seldom a problem for CPA firm auditors because they are
not employed by the company being audited. As stated earlier, independence of internal audit
department report to the board of directors or president. Similarly, government auditors should
report to above the operating departments.

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The responsibilities of operational auditors can also affect their independence. The auditor
should not be responsible for performing operating functions in a company or for correcting
deficiencies when ineffective or inefficient operations are found. For example, it would
negatively affect auditors’ independence if they were responsible for designing a computerized
system for purchases or for correcting it if deficiencies were found during an audit of the
purchasing system.

It is acceptable for auditors to recommend changes in operations, but operating personnel must
have the authority to accept or reject the recommendations. If auditors had the authority to
require implementation of their recommendations, the auditor would actually have the
responsibility for auditing his or her own work the next time an audit was conducted.
Independence would therefore be reduced.

Competence is, of course, necessary to determine the cause of operational problem and to make
appropriate recommendations. Competence is a major problem when operational auditing
deals with wide-ranging operating problems. For example, imagine the difficulties of finding
qualified internal auditors who can evaluate both the effectiveness of an advertising program
and the efficiency of a production assembly process. The internal audit staff doing that type of
operational auditing would presumably have to include some personnel with backgrounds in
marketing and others in production.

Criteria for Evaluating Effectiveness and Efficiency

There are several sources that the operational auditor can utilize in developing specific
evaluation criteria. These include the following:

• Historical performance. A simple set of criteria can be based on actual result from prior
periods (or audits). The idea behind using these criteria is to determine whether things
have become “better or “worse” in comparison. The advantage of these criteria is that
they are easy to drive; however, they may not provide much insight into how well or
poorly the audited entity is really doing.

• Comparable performance. Most entities subject to an operation audit are not unique;
there are many similar entities within the overall organization or outside it. In those
cases, the performance data of comparable entities, the data are usually readily
available. Where the comparable entities are outside the organization, they will often be
willing to make such information available. It is also often available through industry
groups and governmental regulatory agencies.

• Engineered standard. In many types of operational auditing engagements, it may be

possible and appropriate to develop criteria based on engineered standards – for
example, time and motion studies to determine production output rates. These criteria
are often time consuming and costly to develop, as they require considerable expertise;
however, they may be very effective in solving a major operational problem and well
worth the cost. It is also possible that some standards can be developed by industry
groups for use by all their members, thereby spreading the cost and reducing it for each
participant. These may be groups in the industry of the subject organization, or
functional groups such as IT users’ organization.

• Discussion and agreement. Sometimes objective criteria are difficult or costly to obtain,
and criteria are developed through simple discussion and agreement. The parties
involved in this process should include management of the entity to be audited, the
operational auditor, and the entity or persons to whom the findings will be reported.

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Keys Steps in Operational Audit
1. Definition of purpose

2. Familiarization
Planning
3. Preliminary survey

4. Program development

Evidence Accumulation
and Evaluation 5. Fieldwork

6. Reporting the findings

Reporting and Follow-up
7. Follow-up.

I. Planning Phase

Definition of Audit Purpose

Broadly, the purpose of an operational audit usually includes the intention to appraise the
performance of a particular organization, function, or group of activities. However, this broad
statement must be expanded to specify precisely the scope of audit and the nature of the report.
The auditors must determine specifically which policies and procedures are to be appraised and
how they relate to the specific objectives of the organization.

Familiarization
Before starting an operational audit, the auditors must obtain a comprehensive knowledge of
the objectives, organizational structure, and operating characteristics of the unit being audited.
This familiarization process might begin with a study of organizational charts, statements of the
functions and responsibilities assigned, management policies and directives, and operating
policies and procedures. At this stage, the auditors may read some of the published material
available on the subject to acquaint themselves as fully as possible with the functions
performed. This background information equips the auditor to visit the organization’s facilities
and interview supervisory personnel to determine their specific objectives, the standards used
to measure accomplishment of these objectives, and the principal problems encountered in
achieving these objectives. During these visits, the auditors will also observe the operations and
inspect the available records and reports.

Preliminary Survey
The auditors’ preliminary conclusions about the critical aspects of the operations and potential
problem areas are summarized as the auditors’ preliminary survey. This survey serves as a
guide for the development of the audit program.

Development of the Audit Program

The operational audit program is tailor-made to the particular engagement. It contains all the
tests and analyses the auditors believe are necessary to evaluate the organization’s operations.
Based on the nature and difficulty of the audit work, appropriate personnel will be assigned to
the engagement, and the work will be scheduled.