internal audit proficiency and internal controls

LITERATURE REVIEW

9.0 Introduction
This chapter is a review of the related literature generated by the researcher on the subject of study. The chapter entails the relationship between internal audit proficiency and internal controls; internal controls and corporate governance; internal audit proficiency and risk management; internal controls and risk management; and risk management and corporate governance.
9.1 Internal Audit Proficiency
Internal auditors should possess the knowledge, skills, and other competencies needed to perform their individual responsibilities. The internal audit activity collectively should possess or obtain the knowledge, skills, and other competencies needed to perform its responsibilities. The internal auditor should have sufficient knowledge to identify the indicators of fraud but is not expected to have the expertise of a person whose primary responsibility is detecting and investigating fraud. (IIA, 2007). The rationale is that internal auditors’ experiences, knowledge and education are most valuable to management (Giselle, 2000).

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9.2 Internal Audit Proficiency and Internal Controls
From the definition of internal auditing, the objective of internal auditing not only includes involvement in governance but also highlights the importance of evaluating and improving control and risk management (IIA, 2007). Most internal audit professionals argue that an effective internal audit function clearly correlates with an organisation’s success in meeting management objectives and whether the internal control system is functioning as intended (Faudziah et al, 2005). The effectiveness of internal audit greatly contributes to the effectiveness of each auditee in particular and the organization at large (Dittenhofer, 2001). Dittenhofer (2001) also observed that, if internal audit quality is maintained, it will contribute to the appropriateness of procedures and operations in the organization. Therefore, internal audit proficiency is seen as an important attribute to the quality of the internal audit function and the way it adds value to the internal control frame work.
The Institute of Internal Auditor’s Standard 1210 on proficiency of auditors, requires that internal auditors posse the knowledge, skill and other competencies needed to perform their responsibilities (IIA, 2007). Internal audit effectiveness is determined by the internal audit department’s capability to provide useful findings and recommendations and to prove that it is of value to the organization and promotes good governance within the organization.
Internal auditors need specific technical skills and to be seen to undertake continual professional development to keep up to date with changing business practices and remain capable of providing a value-added service in their audit approach (Giselle, 2000). They should therefore be experts in the area of internal control and should use their skills and expertise to evaluate internal control systems of their organizations and recommend improvements that will greatly contribute to good governance. According to Jan Cattrysse (2005), internal audit could have an important input based on their experience from independent monitoring operations or previous occurrences of wrongdoing.
9.3 Internal Audit Proficiency and Risk Management.
The role of internal audit is to provide objective assurance to those charged with governance and management on the adequacy and effectiveness of the risk management framework, help in improving the processes by which risks are identified and managed, help in strengthening and improving the risk management framework.
According to (Herdman 2002; Richards 2002; Bailey et al. 2003; Gramling et al. 2004; Carcello et al. 2005b; Deloitte 2005; Gadziala 2005), the internal audit function plays a unique and critical role in corporate governance by monitoring organizational risks and helping ensure financial reporting reliability.
Chris Jeffrey (2008) asked that, if an internal audit group does not clearly understand the industry, how could it decipher what the greatest risks to the organization were? In order to do all this, internal auditors need to be skilled and experienced on how risk management works. They also need to gain a better understanding of the key business risks and the impact they can have on the organization’s ability to build shareholder value (risk assessment). Internal auditors must also be able to assess the responses to key exposures and determine if those responses are sufficient or relevant (Gerrit and Ignace, 2006).
Spira & Page (2003), note that the recent corporate governance guidelines assume that risks can be objectively identified, quantified and thus strategically managed. Consequently, expertise in risk management techniques and knowledge about the internal control system become a source of power which enables internal auditors to advance and play an important role within their organization. Companies facing higher risk will increase their organizational monitoring through internal audit, providing evidence of the importance of the internal audit function (Colin et al, 2008).
Lastly, according to Ian & William, (2007), one external auditor commented that the internal audit profession had been trying to reposition itself over the last six or seven years from being relatively unfashionable function: “I’m not saying that it was just re-badging. They have been taking on new skills and repositioning themselves more as risk advisory/ management people”.
9.4 Internal Controls and Risk Management.
According to the new definition of internal controls by the Institute of Internal Auditors (IIA, 2007), controls do not exist in a vacuum and implies, rather, that controls exist to assist organizations in managing risk and promoting governance processes. A company’s system of internal controls has a key role in the management of risks that are significant to the fulfillment of its business objectives. It is important to note therefore, that a sound system of internal control provides reasonable, but not absolute, assurance that a company will not be hindered in achieving its business objectives by circumstances which may reasonably be foreseen.
Risk in a financial context is generally understood to be the potential for financial loss consequent on fraud and incompetence. Although it is widely understood that such risk can never be entirely eliminated, it is generally believed that a system of internal control will act as a deterrent to fraud and a protection against incompetence (Spira & Page, 2003). Gerrit & Ignace, (2006), noted that internal controls are only one of the means to manage key organizational risks. Other devices used to manage risks include the transfer of risks to third parties, sharing risks and the withdrawal from unacceptably risky activities.
9.5 Risk Management and Corporate Governance
From an agency perspective, the importance of strong governance stems from the need to align the interests of management with other stakeholders in the firm in order to reduce agency costs (Cohen et al., 2002). One of corporate governance mechanisms that can be used to monitor management’s behaviour is internal audit (Davidson et al., 2005). Internal auditors are certainly exhorted in the professional literature to embrace the opportunity to contribute to the achievement of corporate objectives through risk management (Gerrit & Ignace, 2006).
9.6 Internal Controls and Corporate Governance
 

Importance Of Audit Evidence Accounting Essay

According to Companies Act 1965 Section 174, auditor should perform the following duties, Statutory Duties. Auditor should examine and form an opinion whether the financial statements compliance the financial reporting standards of Malaysia and the Companies Act 1965.
Duty to carry out audit. Auditor should examine and form an opinion whether the financial statements give a true and fair view of the financial position of the Company as of the financial year end and of its financial performance and cash flows of the year end.
Duty to report to appropriate management. Auditor should report the accounting and other records and the registers required by the Companies Act to be kept by the company have been properly kept in accordance with the provisions of the Act.
Duty to be independent. Auditor is under a duty to exercise the appropriate standard of care to shareholders and outsiders.
Duty to use reasonable care and skill. Auditor should obtain reasonable assurance that the financial statements are free from material misstatements.
(2) “The auditor must plan the audit so as to enable him/her to detect all misstatements”. Discuss.
The purpose of planning stage is plan the audit so that it will be performed in an effective manner. During the planning stage, auditor should design and perform the audit planning to detect the potential threat that may be occurred and also limited the audit risk to a lower level. Auditor will get the knowledge of the client’s business, auditor able to identify the potential threat that may be occurred. The planning stage will be emphasis on the material misstatement based on the professional judgement but not absolute detect all the misstatement such as immaterial misstatement will not be concern.

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(3) Explain the steps to be taken by the auditor if there are reasons to believe that there are (i) errors and (ii) frauds.
According to SAS 110, the auditors shall indicates that fraud or error that exist by obtaining an understanding of the nature of the event and the circumstances, and sufficient other information to evaluate the possible effect on the financial statements. If the auditors believe that the indicated fraud or error could have a material effect on the financial statements, they should perform appropriate modified or additional procedures.
Where there is a significant error or fraud, the auditor should consider the necessity for a disclosure of the error or fraud in financial statements, and report to the relevance third party (management level). If adequate disclosure is not made, the necessity for a suitable disclosure in his report so called qualified audit report.
(4) What is an audit engagement letter? What steps should be taken by the auditor after receiving the audit engagement letter?
According to standard, audit engagement letter refers to a written contract between accounting firm and the client. Its purpose is to confirm the relationship between the client engaging the auditor and the accounting firm accepting the audit engagement and to define matters such as the objectives of the engagement, the scope of the audit, the responsibilities and duties of each party etc. The audit engagement letter has statutory binding force.
After receiving audit engagement letter, there will be an interview or opening conference between engagement parties and audit firm. During the meeting, auditee is asked about the system to be reviewed available resources and other relevance resource. The auditor may be required to meet the person in charge those relevance resources.
After getting the required information, auditor will perform a general overview on it and review the internal control of the auditee in order to determine the audit risk that may be occurred.
(5) What are the purposes of the audit working papers?
1. To provide a basis for planning the audit. The auditor may use reference information from the previous year in order to plan this year’s audit, such as the evaluation of internal control, the time budget, etc.
2. To provide a record of the evidence accumulated and the results of the tests. This is the primary means of documenting that an adequate audit was performed.
3. To provide data for deciding the proper type of audit report. Data are used in determining the scope of the audit and the fairness with which the financial statements are stated.
4. To provide a basis for review by supervisors and partners. These individuals use the audit documentation to evaluate whether sufficient appropriate evidence was accumulated to justify the audit report.
Audit documentation is used for several purposes, both during the audit and after the audit is completed. One of the uses is the review by more experienced personnel. A second is for planning the subsequent year audit. A third is to demonstrate that the auditor has accumulated sufficient appropriate evidence if there is a need to defend the audit at a later date. For these uses, it is important that the audit documentation provide sufficient information so that the person reviewing an audit schedule knows the name of the client, contents of the audit schedule, period covered, who prepared the audit schedule, when it was prepared, and how it ties into the rest of the audit files with an index code.
(6) Describe the different types of information that are kept in the current file.
Current audit file include following resources:
Audit plan, report and audit programme’s copies
Clearance the problems and confusion during the time of audit work such as journal entries and minutes of meetings.
Copies of annual records such as trade account, trial balance and profit and loss account and balance sheet
Bank reconciliation statement
Minutes of meetings
Current financial statements
Working papers supporting account
Paper of calculation of tax bonus.
List of lost proofs
Paper regarding stock evaluation
(7) State the nature and the importance of audit evidence.
According to ISA, there is nine type of audit evidence which include physical examination, confirmation, documentation, analytical procedures, inquiries, scanning, recalculation, reperformance and observation. The nature of audit evidences includes invoices, contracts, and worksheets, general and subsidiary ledger and so on.
Audit evidence is important as it provides the auditor with the information regarding the potential threat or weakness that may be occurred in the client’s financial statements. Audit evidence is useful as it provides the auditor with some degree of competent evidential support for the expression of an audit opinion. It facilitates the completion of audit programme scheduled and undertaken.
(8) According to ISA 500, what type of evidence is the auditor required to collect?
According to ISA 500, auditor required to collect sufficient and appropriate audit evidence in order to draw reasonable conclusions on which to base the audit opinion. Sufficiency and appropriateness are interrelated and apply to audit evidence obtained from both tests of controls and substantive tests.
Sufficiency is a measure of the quantity of evidence and it refers to sample size and items to select. Higher quality evidence results in a lower quantity of audit evidence.
Appropriateness is a measure of the relevance and reliability of evidence, or the degree to which evidence can be considered believable or worthy of trust. Appropriateness relates to the audit procedures selected, including the timing of when those procedures are performed.
 

Perception of the Effectiveness of Internal Audit Function

Management is constantly striving to effectively its objectives and protect assets. Therefore, management needs to continually evaluate the activities of every department in their organisation. Internal audit (IA) has become an important and an integral function of organisations in achieving their objectives and protecting assets. Thus, a study of the role and effectiveness of internal audit function in developing countries such as Libya could enable an understanding of internal audit practice where, currently, there are no local standards on how the effectiveness of those departments can be evaluated. Libya is a developing Arab state located in north central Africa with an area of 1,759,540 square kilometres (1,092,882 square miles) and aـــ Mediterranean coastline nearly 1,800 kilometres long (1,118 square miles) from Tunisia in the west to Egypt in the east.

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Limited prior research has focused on the effectiveness of internal audit (EIA). Also, previous research has failed to determine a generally agreed approach to ascertain the effectiveness of internal audit function. Employing institutional theory and Marx’s theory of the circuit of industrial capital, this study seeks to explore and interpret the opinions of the participants regarding the role and effectiveness of internal audit in Libyan public enterprises. It aims to introduce a new perspective for the evaluation of internal audit effectiveness by identifying two groups of factors that impact on audit effectiveness, that is, those related to Standards for Professional Practice of Internal Auditing (SPPIA) namely, independence, competences, scope of work and work performance and those related to organization management support namely, salaries and material and moral incentives.
The study will utilize a qualitative research paradigm to establish whether the internal audit function in Libyan public enterprises is perceived to be effective. Interviews will be used to collect data from managers of administrative affairs, financial controllers, directors of internal audit in public enterprises operating in manufacturing, banking and insurance sectors, and external auditors responsible for these enterprises.
THE RESEARCH PROBLEM AND ITS SETTING
Research Setting
The professional practice of IA commenced around 1941. Before the 1950s, IA focused on financial audit and was heavily involved in the review of financial statements. Since 1941 the Institute of Internal Auditors (IIA) has played an important role in developing and enhancing the professional stature of internal auditors (Yee et al. 2008). IIA (2004) defined internal auditing as:
“An independent, objective assurance and consulting activity designed to add value and improve an organization’s operations. It helps an organization accomplish its objectives by bringing a systematic, disciplined approach to evaluate and improve the effectiveness of risk management, control, and governance processes”.
According to this definition internal auditors should play a relevant role in evaluating and improving the effectiveness of risk management processes. This statement also reflects the Marxist definition of internal auditing that modern operational auditing seeks to increase the rate of return on capital, as well as value adding (Yee et al. 2008). Recently, IA has became an important part of organizational structure as a value adding service to organizations (Al-Twaijry, Brierley & Gwilliam 2003; Arena & Azzone 2009; Bou-Raad 2000; 2005; Coram, Ferguson & Moroney 2008; Enyue 1997; Goodwin 2004; Mihret, D. G. & Woldeyohannis 2008; Yee et al. 2008). Al-Twaijry, Brierley and Gwilliam (2003) explain that there are two benefits in having an internal audit department with in organizations. Firstly, it improves the operations and manages risk. Secondly, it helps the organization in the prevention and detection of mistakes or fraud, and the safeguarding of the assets of the organization. Therefore, the objective of IA is to examine and evaluate the adequacy and effectiveness of other controls in order to provide the management of an organization with information, analyses and recommendations to assist them in achieving its objectives (Bou-Raad 2000; Brody & Lowe 2000; Goodwin 2004; Yee et al. 2008).
Furthermore, IA is an important tool for external audit because the work of internal audit can help external auditors in many respects. For example internal auditors may enable external auditors to understand the internal control system before any work is being carried out (Haron et al. 2004). For external auditors to rely on the work of internal auditors, the external auditors must assess the work of the internal audit function. The American Institution of Certified Public Accountants (AICPA) has issued Statement of Auditing Standards SAS No. 65 and has determined EIA in three criteria, namely, competence, objectivity and work performance. Several previous research has studied the external auditors’ reliance on internal audit work, in particular, Al-Twaijry, Brierley and Gwilliam (2004) point out that the external auditor expressed concern about the independence, scope of work and small size of many internal audit departments in the Saudi Arabian corporate sector.
The importance of IA has been confirmed indirectly in various legislation, such as the Sarbanes Oxley Act (2002) in the USA, and the Corporate Law Economic Reform Program Act in Australia (Carey, Subramaniam & Ching 2006). Also, recent corporate collapses and financial scandals have increased attention on IA as an important consideration for organizations (Arena, Arnaboldi & Azzone 2006; Coram, Ferguson & Moroney 2008; Schneider 2003).
Although (IA) has become a very important function within organisations, academic researchers have largely ignored IA as an organisational control function due to the lack of internal audit research compared to that on external audit (Boyle 1993). According to Mizrahi & Ness-Weisman (2007, p. 188): “Yet, there is relatively little in the literature about the measurement of auditing effectiveness in the public sector”. Currently this should not be ignored as the international market is becoming more and more open. However IA, in order to be a value adding service to organizations, must be effective (Mihret, D. G., James & Mula 2009a). According to Mousa (2005, p. 6) :
“There are two basic reasons why it is important to examine and evaluate EIA. One is that it is an indication of the quality of performance and can describe whether or not the IA function is performing in a satisfactory manner. The second is that the evaluation can serve as a motivator for an individual or an organisation to achieve a better performance”.
Mizrahi & Ness-Weisma (2007) maintain that in general, two important tools for achieving managerial accountability in the policy-making process are evaluation and auditing.
Despite scholars’ attempts to measure and evaluate EIA, there is no generally acknowledged guide or tool for this purpose (Arena & Azzone 2009). For this reason, prior research has differed in determining the effectiveness of the internal audit function in three ways. Firstly, previous research has utilized a variety of criteria to determine EIA. For example, Haniffa and Cooke (2002) and Mihret, James and Mula (2009c) studied the influence of environmental factors on internal audit’s practice. Al-Twaijry, Brierley and Gwilliam (2003), Mihret, James & Mula (2009b), Mihret, Mula & James (2009d) and Yee et al. (2008) have used (SPPIA) as a guideline to evaluate EIA. Arena and Azzone (2009), Elliott, Dawson and Edwards (2007) and Mihret and Yismaw (2007) have developed models to evaluate EIA. Secondly, while some prior research has examined EIA from the point of view of the organization (managers, the chief audit executive and internal audit staff), others have depended on external auditors’ perceptions. Thirdly, most previous research has focused on mixed sectors (public sector, private sector and government ministries).
The mission of IIA is to provide dynamic leadership for the global profession of internal auditing (IIA 2004). SPPIA are an effective indication to determine EIA (Al-Twaijry, Brierley & Gwilliam 2003). Mihret, James and Mula (2009b, p. 10) argue that:”The use of SPPIA provides a better proxy measure because it helps to measure internal audit effectiveness by examining internal audit systems and processes”. A positive association between compliance with SPPIA and organizational goal achievement could be an additional indicator of effective internal audit (Mihret, D. G., James & Mula 2009b). For internal auditing to be a value-added activity, it is important for internal auditors to comply with SPPIA (Al-Twaijry, Brierley & Gwilliam 2003).
Internal audit’s practice would not be effective without management support. Adams (1994) explained that the interest of management is an important factor in maintaining a strong IA. Mihret and Yismaw (2007) perceived management support as one of the two most important factors influencing audit effectiveness. Management support such as pay rates and material and moral incentives could improve EIA. Mihret, James and Mula (2009c) state that most participants in their study believed that poor pay rates and career prospects in the public sector had the potential to limit EIA. Albercht et al (1988) found that there are four factors that the directors of internal audit departments could develop to enhance EIA top management support, namely, (i) an appropriate corporate environment; (ii) high quality internal audit work; (iii) high quality internal audit staff; (iv) and an appropriate corporate environment.
Libya is a developing Arab state located in north central Africa with an area of 1,759,540 square kilometres (1,092,882 square miles) and a Mediterranean coastline nearly 1,800 kilometres long (1,118 square miles) from Tunisia in the west to Egypt in the east (for more detail seeOtman & Karlberg 2007). Libyan public enterprises are the most important source of capital formation. In most of these enterprises internal audit departments have been established to evaluate the activities of the organizations. However, there is no rule that tells organizations how to manage their internal audit departments and, contrary to the West, there are no professional standards and guidelines available to internal auditors in Libya, resulting in organizations having their own internal guidelines on the practice of IA (Almagory 1998).
In line with the new trends of the Libyan society towards encouragement of domestic and foreign investment, establishment of a stock exchange and adoption of international accounting standards by the banking sector and stock market, there is a need to investigate the conditions of the accounting and auditing profession in the Libyan environment (Alhsadi 2007). As a starting point in this direction, those who follow the reality of financial accounting in the Libyan environment tend to emphasize the weakness of the Libyan experience, especially in the professional field (Al-Kilani 2002; Ashour 2004). Libya’s Commercial Law for the year 1953 had put forward an integrated accounting financial accounting model requiring each company to establish an internal audit department (Alhsadi 2007). Moreover, according to proclamation No. 116 of 1973, all Libyan public organizations, be they industrial, commercial, or services related, are subject to external audit. However, more recently, all Libyan public organizations have been required to undergo audit by public auditors (that is, the staff of the Management Control Institution). In Libya the public sector still dominates the economy, consistent with socialism.
Research Questions
This research arises out of the need to evaluate EIA in Libya (Arena, Arnaboldi & Azzone 2006; Arena & Azzone 2009; Christopher, Sarens & Leung 2009; Conor & Jenny 2007; Coram, Ferguson & Moroney 2008; Goodwin 2004; Mihret, D. G. & Yismaw 2007). More specifically, Al-Twaijry, Brierley & Gwilliam (2003); Mihret, Admassu and Abdalla (2009e); Mihret, James and Mula (2009c); Mihret, Mula and James (2009d); Mihret and Woldeyohannis (2008); Mihret and Yismaw (2007) and Yee et al.(2008) suggest the need to focus on IA in developing countries. Because IA has become an integral part in modern business, the internal auditor’s role is becoming increasingly important to organizations in achieving their objectives. Also, with the rapid growth of the public sector and resultant serious problems concerning organizational control and supervision, management needs to continually evaluate the activities of every section of their organisation that impact on achieving efficiency and protecting assets (Yee, Sujan & James 2007).
In all Libyan public enterprises internal audit departments have been established to evaluate the activities of organisations as a service to management. Despite the importance of evaluating EIA in various economic activities in Libya, no formal guidelines have been provided to support this evaluation. Furthermore, some of the previous studies on IA in Libya have concentrated on activities such as industrial activities (Ashour 2004) and the banking sector (Elmasallati 1995). Therefore, it is apparent that there is a need for research to examine and evaluate the effectiveness of the internal audit function within the Libyan context where there are no standards on how the effectiveness of those departments can be evaluated. As a result this study is concerned with EIA in Libyan public enterprises. Thus, this study seeks to examine EIA Libyan public enterprises. Therefore, the main question underlying this research study is:
Research Question: To what extent is the internal audit function in Libyan public enterprises perceived to be effective?
Thus, to answer the main question underlying this research study, the following eight subsidiary questions are formulated:
RQ1: To what extent is the internal audit function in Libyan public enterprises independent of management?
RQ2: Does the scope of internal auditing actually extend into other types of non-financial (managerial / operational) areas at all management levels and can it be identified?
RQ3: To what extent are the internal auditors competent, in terms of knowledge and skills?
RQ4: To what extent is the performance of internal audit effective, in terms of managing internal audit activity, nature of work, engagement planning, performing the engagement, communicating results and monitoring progress?
RQ5: Is internal audit in Libya operating under adequate management support in terms of salaries and material and moral incentives?
RQ6: Are organizations in Libyan aware of the social benefit of effective internal auditing?
RQ7: What programs and actions should be implemented to improve EIA?
RQ8: What can be done to attract and nurture skilled and talented young people into internal auditing in Libya?
Scope of Study
This study will focus on six factors independence, competences, scope of work and work performance, salaries and material and moral incentives to examine EIA. However, it will not consider other factors such as environmental factors. The study will focus on public enterprises which are state-owned. It will not include private enterprises. Furthermore, it does not purpose to study external auditors’ reliance on internal audit work. Rather it will explore the external auditors’ opinion about EIA in Libyan public enterprises.
Research Objectives
The present study aims to obtain the opinions of the participants regarding the role and effectiveness of internal audit in Libyan public enterprises. It will introduce a new perspective for the evaluation of internal audit effectiveness by identifying two groups of factors that impact on audit effectiveness, that is, those related to SPPIA, namely, independence, competences, scope of work and work performance and those related to organization management support namely, salaries and material and moral incentives. In other words, the answers to questions one to six will introduce the opinions of the participants regarding the role and effectiveness of internal audit. In addition, the answers to questions seven and eight will provide recommendations and suggestions on how EIA could be improved in the future.
Contribution
The following points will explain how the study contributes to knowledge:
First, this research will contribute to the literature relating to EIA. Boyle (1993, p. 227) states that: “compared to that on external audit, the academic literature on IA is limited”. Boyle also found 21 articles on the subject of IA during the period from 1975 to 1990 and none of which dealt with how its effectiveness can be evaluated. This lack of research is particularly critical to developing countries. Due to the lack of internal audit research on Middle-Eastern and North African companies, Al-Twaijry, Brierley and Gwilliam (2003); Mihret, Admassu and Abdalla (2009e); Mihret, James and Mula (2009c); Mihret, Mula and James (2009d); Mihret and Woldeyohannis (2008); Mihret and Yismaw (2007) and Yee et al. (2008), this study will provide insights on IA in Libya and whether the internal audit functions in Libyan public enterprises is effective, , thereby enhancing academics’ understanding of the merits and limitations of IA in Libya. Moreover, the contribution of the study is not restricted to the Libyan environment. It extends to the wider field of IA research. It will be especially relevant for communist and ex-communist countries such as Russia, Vietnam, Cuba, China, and the countries of Eastern Europe.
Second, this study is the first to research issues concerning evaluation of the internal audit function in public enterprises operating in manufacturing, banking and insurance sectors in developing countries, and particularly Libya, where there is no rule that instructs organizations on how to manage their internal audit departments. Unlike the West, there are no professional standards and guidelines available to internal auditors in Libya, resulting in organizations having their own guidelines on the practice of IA.
Third, this study will fill an important gap in the previous research regarding measuring and evaluating the effectiveness of internal audit function. Mihret and Yismaw (2007) used management support as factors in determining EIA in Ethiopia. However, the management support factors did not include the salaries and material and moral incentives which could affect EIA. Mihret and Yismaw (2007) point out that future research would be welcome to fully understand the level of internal audit effectiveness in the public sector by defining other variables affecting IA. Mihret, Mula and James (2009d, p. 1) highlight that: “Internal audit effectiveness needs to be conceptualized separately in industries and sectors could yield useful insights”. Therefore, this study will introduce a new perspective for the evaluation of internal audit effectiveness by identifying two group of factors that impact on audit effectiveness, that is, those related to SPPIA (independence, competencies, scope of work and work performance) and those related to management support (salaries and material and moral incentives). Also, the participants in most previous studies were external auditors, however, this study will use both a view of the organization (manager of administrative affairs, financial controllers and director of the internal audit) and external auditors responsible for this organization. Furthermore the study will provide recommendations and suggestions to improve and develop EIA.
Fourth, the majority of previous research has used quantitative research to examine IA and has used a questionnaire for data collection. However, this study will employ qualitative research to examine EIA. It will utilise the interview method for data collection. As mentioned in previous research, there is no generally acknowledged guide or tool for measuring and evaluating EIA. This study will contribute to the literature knowledge regarding evaluation EIA by using qualitative data because in qualitative research researchers do indeed dig deep to acquire a complete understanding of the phenomenon (Leedy & Ormrod 2005). Therefore, by the use of qualitative research (interview data collection), this study will comprehensively investigate the factors affecting the effectiveness of internal audit function. The benefits of qualitative research for the precent study will be explained in more detail in the in research methodology section of this proposal.
Fifth, most previous research has focused on IA in different sectors (private and public sectors). However, this study will focus primarily on public enterprises for reasons which also will be explained in the research methodology section.
LITERATURE REVIEW
Internal Audit Effectiveness
There has been limited research on internal audit effectiveness. This prior research suggests that the internal audit function has evolved from performing traditional IA function to becoming a value adding attribute to the organization (Al-Twaijry, Brierley & Gwilliam 2003; Allegrini et al. 2006; Arena, Arnaboldi & Azzone 2006; Arena & Azzone 2009; Cooper, Leung & Wong 2006; IIA 2004; Mihret, D. G., Mula & James 2009d; Yee et al. 2008)). IIA (2004) defines internal auditing as an independent, objective and consulting activity designed to add value to an organization. Mihret, Mula and James (2009d) explain that organizations must understand internal audit effectiveness to assess the value adding potential of IA. Thus, in order for IA to be considered as a value adding service to organizations, it must be effective (Mihret, D. G., James & Mula 2009a).
Prior research has differed in determining the effectiveness of internal audit function. Al-Twaijry, Brierley and Gwilliam (2003) studied the development of IA in the Saudi Arabian corporate sector by using institutional theory. They highlighted that it is important for internal auditing to comply with SPPIA to be a value added activity. They also used SPPIA in terms of quality of internal audit staff, quality of internal audit work, an appropriate corporate environment and support of top management to evaluate EIA. The results of this study show that IA in the Saudi Arabian corporate sector is ineffective and it is not a value adding service to organizations. The study results also highlighted that managers have not implemented the recommendation of IA. These authors also suggest that future research is necessary to evaluate EIA accurately, because factors used in this study may act to reduce the value of IA.
Mihret and Yismaw (2007) also studied EIA in public sector higher educational institutions in Ethiopia. The study identified four factors impacting EIA, that is internal audit quality, management support, organization setting and auditee attributes. The results indicate that IA is ineffective in terms of proficiency, planning, recommendations and the limitation to the scope of work. Furthermore, this study revealed that audit quality and management support are the two most important factors influencing audit effectiveness respectively. These researchers also suggest a need for future research to fully understand EIA in the public sector by identifying other variables affecting internal audit effectiveness.
Yee et al. (2008) studied the role and effectiveness of internal audit in Singapore. They examined the perceptions of Singapore senior, middle and junior managers regarding the role and effectiveness of internal audit. In contrast to prior research, this study is the first to apply Marxist economic theory on the internal audit function. In contrast to Saudi Arabia (Al-Twaijry, Brierley & Gwilliam) and Ethiopia (Mihret, D. G. & Yismaw 2007), Yee et al.’s (2008) overall findings were that 1) the internal audit function in Singapore is improving and has became an important part of the organizations’ structure as a value adding service to organizations; and 2) In general, managers are satisfied with the internal audit. They also recommended the need to explore the role and effectiveness of internal audit in the Middle-East, because in a developing country the internal audit function can ensure that capital is not wasted through inefficiency, fraud and corruption.
Mihret, Mula and James (2009d) have studied EIA in three different organizations, government ministries, state-owned companies and private companies. Similar to that of (Al-Twaijry, Brierley & Gwilliam 2003), their study employed institutional theory perspective to examine EIA. They also used major elements of SPPIA to measure EIA. The results of their study suggest that the level of internal audit effectiveness varies between these organizations. Also, the internal audit’s authority and responsibility, and its link with top management, are important factors in enhance EIA. The authors suggest that internal audit effectiveness needs to be conceptualized separately in industries and sectors could yield useful insights.
Arena and Azzone (2009) state that in light of recent changes in the role of internal audit function their study attempts to identify the organizational drivers of internal audit effectiveness in Italian companies. They indicate that, the role of IA has increased recently because of its links to the internal control-risk management system. This study defined a model to measure internal audit effectiveness that included EIA as dependent variable; and resources and competencies of internal audit team, the audit processes and activities and the level of interaction between IA and audit committee as independent variables. The results of this study suggest that internal auditors need to create new skills to perform activities that are more closely related to risk management because risk management needs auditors who are able to deal with different sources of risk and to increase the managers’ confidence in risks and controls. The results of this study also explain that internal audit effectiveness is influenced by the characteristics of the internal audit, the audit processes and activities and the organizational links. Arena and Azzone (2009, p. 43) state that:
“Internal audit effectiveness increases in particular when the ratio between the number of internal auditors and employees grows, the Chief Audit Executive is affiliated to the Institute of Internal Auditors, the company adopts control risk self-assessment techniques, and the audit committee is involved in the activities of the internal auditors”.
Furthermore, the authors highlight the need for more detailed analysis on the internal auditor’s competences in order to understand which specific skills can influence internal auditors.
Goodwin (2004) has made a comparison between the role of IA in the public sector and those in the private sector in Australia and New Zealand. The author highlights that there is no requirement for private sectors in Australia and New Zealand to establish internal audit department, however, the Australian Stock Exchange encourages large companies to have such a department. Regarding the requirement to establish an internal audit function in Australian public sector is not clear because it depends on the specific legislation governing them. On the other hand within the public sector in New Zealand there is no requirement to have an internal audit function. The results have suggested that internal auditors in the public sector are less likely to report to the chief of financial affairs than those in the private sector. Although the two sectors have used outsourcing to achieve some internal audit work, public sector organizations are more likely to use an external auditor for these services. Also, there does not appear to be any significant difference between internal auditors in the two sectors in interaction with external auditors.
Summary
Recently, the internal audit function has changed from a traditional function to becoming a value adding one to organizations, but for internal auditing to be a value added function, it must be effective. Therefore, prior research suggests that it is important for the organisation to evaluate EIA to ensure that it provides value to the organisation. However, previous research indicates that IA may not always be effective. Additionally, the role of the internal audit function is different between private and public sectors. It appears that there is a gap in previous research regarding examining EIA. It has utilized different criteria to determine EIA, as well as focussing on mixed sectors (public sector, private sector and government ministries). In addition, it has used different theories. Most prior research has suggested the need for future research to examine EIA, Therefore, exploration of EIA in developing countries such as Libya could contribute significantly in reducing the gap in literature.
The Theoretical Framework
The study seeks to determine EIA based on six factors independence, competence, scope of work, work performance, salaries and material and moral incentives. Thereafter, it will focus on how EIA in public enterprises could be improved in the future. Institutional theory and Marx’s theory will be employed in order to achieve the research aims. Following is a brief discussion of institutional theory and Marx’s theory and the explanation for combining them within this study.
Institutional Theory
Prior research has employed institutional theory to study IA (Al-Twaijry, Brierley & Gwilliam 2003; Arena, Arnaboldi & Azzone 2006; Mihret, D. G., James & Mula 2009b; Mihret, D. G., Mula & James 2009d). Institutional theory focuses on aspects of social structure and provides an explanation for how institutional patterns, structures and practices are shaped through coercive, mimetic and normative isomorphism (DiMaggio & Powell 1983) . The importance of institutional theory lies in the demonstration that what an organization actually accomplishes and what their structures suggest to the external environment, they should accomplish (Fogarty 1996). However, organizations may exhibit to the external environment that they are operating in line with that expected by the external environment while, in fact, they are not (Meyer & Rowan 1977). Institutional theory explains that organizations sometimes engage in decoupling. Al-Twaijry, Brierley & Gwilliam (2003) embraced the isomorphic perspective for investigating the development of internal Audit departments in Saudi Arabia. According to Al-Twaijry, Brierley & Gwilliam (2003, p. 513) “we consider that the actual operations of internal audit departments are decoupled from the expectations of how they operate as stated in SPPIA”. Institutional theory provided a perspective regarding their results, IA is not well developed.
Institutional theory is considered suitable for internal audit research for the following reasons. Firstly, the theory encompasses internal audit practices which are a part of all organizational phenomena. Secondly, it helps to explain organizational phenomena without assuming a limited set of organizational goals compared to agency and transaction cost theories which are predicated on the assumption of shareholder wealth maximization. Third, it could support audit research in countries where the market is under development (Mihret, D. G., James & Mula 2009b). Prior research suggests the theory validity in internal audit research, both in developing countries (Al-Twaijry, Brierley & Gwilliam 2003; Mihret, D. G., Mula & James 2009d) and developed countries (Arena, Arnaboldi & Azzone 2006).
Marx’s Theory of the Circuit of Industrial Capital
Katz and Kahn (1966) defined the effectiveness as ma
 

The cost and benefits of an internal audit

Every internal audit role should be established with a charter approved and reviewed annually at board level. The internal audit charter should describe the internal audit role in the organization it serves, including its purpose, authority, responsibility, and relationships with external organizations. The internal audit charter should be promoted across the organization at all levels and as appropriate across its supply chains and to its stakeholders. Internal audit should have measures in place to demonstrate its level of performance to the organization. Expectation gaps at organization and individual customer levels should be identified, and all performance measures continuously monitored if the full added value of the internal audit role is to be achieved. New dimensions of the internal audit role in an organization should be continuously explored to ensure that it is at the cutting edge of its professional attributes and in its performance.
Chapter 1
Cost of internal audit
There are two types of internal audit cost
Financial cost
Operational cost
Financial cost
Financial cost of internal audit is those cost that would pay to employees. Organization gives some pays to his employees who conduct internal audit.
Operational cost
Company spend some operational cost when internal audit conducted in the organization e.g stationery documentation
Cost/benefits analysis
While the cost of internal audit is easily quantifiable, measuring its benefits is less straightforward since internal audit may have both direct and indirect effects .
The relevant benefits of internal audit often main fest themselves on several levels and may not be immediately visible
Cost savings are easier to allocated directly than other benefits.
By establishing a correlation between the potential benefits and the costs in cured by the internal audit .Internal audit Department and approximation of the profitability can be obtained .
Efficiency measurement.
It can be very important to measure the efficiency of internal audit work. It involves examining the ratio of costs incurred by internal, Audit during the course of a specific audit, or the cost of the entire internal audit deparment, compared with the actual benefits achieved for lthe company as a whole,
The following criteria can b e used to analyze each audit with regard to the benefits it delivers in the short, medium, and long term.
Cost related benefits (reducing, avoiding, or limiting costs),
Monetary and non monetary benefits ( increased sales, improved operating profits, motivations, reputation,).
Impact on cost.
Generally, the cost impact of an audit can be seen in the short to medium term. Costs normally respond linearly and usually correlate very clearly and closely with their drivers. The can be quantified, for example on the basis of effective payments made, although direct perception declines as the time between implementing the recommendation and the time of payment increases.In addition, imputed costs can be used as part of the analysis. Normally, Imputed costs increase the impacxt of audit findings in area more prone to inducing costs, because ineffective internal controls also lead to costs and expenses that jcould otherwise have been avoided.

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Benefits
While the cost related to internal audits kland the resulting recommendation are relatively straightforward to determine, the benefits are much more difficult to quantify. First, the benefits often continue over long periods of time. Secondly, it is often difficult to measure beenefits and attribute them directly to the process that have brought them about .Benefits are frequently abstract and the interdependencies between cause and effect are often obscure.A complicating factor is that the effects of qualitative and quantitative benefits sometimes overlap and can thus either reinforce or detract from each other. The more geneal the benefit analysis, the more difficult itg will be to reliably assign indicators that map and explain the casual relationship between an audit activity and itgs findings on the one hand and the perceptible benefits on the others.
Deriving Benefits.
Before it is possible to quantify and benefits, representative benchmarks must be defined for each audit field , applying either direct or indirect measures. Quite possibly, audit recommendation will lead to tangible b enefits, such as an improved working atmosphere, greater motivation, or error reduction, which will in turn enhance each employees understanding of values. There may also be a change in the way effects are perceived externally. An improved position in the market place, easier access to finance, and a different public perception, for example, it negative factors are eliminated quickly and with determination and their recurrence is prevented by implementing adequate measures. It is important to recognize that there may be both short term cost savings and longer term benefits gained from internal audit and the implementation on the resulting jcontrol recommendations. Both benefits shold be considered when performing cost/ benefits analysis, even though they may overlap sometimes.
Quantifiable Benefits.
Including quantifiable benefits in the analysis brings up the most difficult aspect of measuring internal Audits efficiency. The main purpose of examining these benefits is to establish a casual link between an audit finding land increased b benefits values for a business unit or the company as a whole. A key challenge in this regard is to extrapolate the quantified benefit created by eliminating a process weakness, thus making it visible.
Organizational and Time delays
With regard to the implementation of audit results organizational effort and time delays should not be ignored. Since each audit field has different c ontent, each must be considered in detail. In business audits for example, linear correlations between audit result and increased jprofits can be established, because there is a direct link between the audit object and the success driver.
Cost Benefit Relationship.
Often, the benefit derived from internal audits is unclear, without a direct link to the measurable benefit related units. Therefore, equivalents must be established by using auxiliary variables to quantify the cost impact and the benefits related to the audit findings.
Standard Cost benefit analysis
To define a standard cost /benefit analysis for each audit field, internal Audit must define and categorize separate bench marks .Thus, Internal Audit is integrated into the business control and decision processes, which results in interdependencies with other disciplines, such as capital investment appraisal, management accounting, and planning.Reduced operating costs through better effic
Benefits of an effective internal audit process
There are number benefits of an effective internal audit process.
They include the following;
Reduced operating costs
Reduced operating costs through better efficiency increased
Productivity, better planning, and reduced scrap and rework.
Some organizations have planned actual revisit on venture on audit conclusion that have totaled well into six and seven information in annual proceeds. Calculating revisit on venture for internal audit conclusion is auxiliary discussed in Chapter 2.
Better safety concert.
Though ISO 9001;2008 does not exclusively address worker health and protection, the necessities
of ISO 9001;2008 and the internal audit course can have a positive collision on safety routine.A good worker instruction process and well-written in service commands supply to an successful professional health and safety supervision arrangement. When these have been joint with the accountability that audits present, many organization have seen significant improvement in their safety routine presently from implement an ISO 9001-based classification.
Better client agreement.
Of course the final ambition of Any excellence administration system is enhanced consumer satisfac-
tion. enhanced customer agreement often leads to an improved customer bottom. Higher levels of consumer happiness also lead to reduction in customer complaint and arrival product, both of which are wealthy to any humanity in provisions of manpower luggage charges, revision and fragment.
better spirits.
Many organization foundation their internal audit course will ask, How do you lay the words’audit’ and
‘better morale’ on the same page exclusive of amused out loud” The answar be simple. When workers are expectant to give To the audit course and see improvement completed base on their participation,
Audits serve to allow the personnel as a substitute of criticism them.
Chapter 2
Introduction
Establishing the internal audit role in any organization require formality to ensure that it is understood not only by the board and management but also by its customer across the organization and, where necessary, those external to the organization The internal audit assurance and consulting role should be explained clearly in a charter to minimize any expectation gaps at board and organization level .The institute of internal auditor as the global professional body representing internal audit in every country, has always recommended and now require in its international standards for professional practice of internal auditing (standard) that “the purpose ,authority and responsibility of an internal audit activity … should be formally approved and kept under review at the highest level in an organization ” in some sector this may be also a requirement of one or more of an organization ‘ stakeholder, such as government or a sector’s regulator
Internal audit definition
Auditing regular ASA 610 allowing for the Work of Internal Audit, issued by the Auditing and declaration Standards Board (AUASB) defines internal audit as follows:
“Internal audit” means an evaluation activity recognized within an unit as a service to the entity. Its functions include, between other things, monitoring internal control.
In calculation, the Institute of Internal Auditors (IIA) has residential the globally conventional definition of ‘internal auditing’ as follows:
‘Internal auditing is an self-determining, objective guarantee and consulting activity planned to add value and progress an organization’s operations. It helps an agency achieve its objectives by bringing a systematic, closely controlled approach to estimate and recover the usefulness of risk management, control and governance processes.’
Instruction
The capacity of internal audit action embraces the wider concepts of corporate governance and risk – recognizing that control exists in an organization to manage risk and support successful governance.
The two types of internal audit manner contemplated by the definition have been defined by the IIA as follows
.assertion Services – an purpose assessment of proof for the reason of as long as an self-regulating evaluation of risk management, control or governance processes for the organization.
.Consulting Services – optional and connected customer activities, the scenery and capacity of which are approved upon with the consumer and which are planned to add value and develop an organization’s operations.
During this paper all references to “internal assessment” will include both of these services. Wed by internal audit organization
History of internal audit
The Internal Auditing occupation evolves gradually with the progress of management science after World War II. It is theoretically similar in many ways to financial auditing by public accounting firms, excellence assurance and banking conformity activities. Much of the speculation fundamental internal auditing is resulting from management consulting and public accounting professions. With the completion in the United States of the Sarbanes-Oxley act of 2002, the profession’s expansion accelerated, as many internal auditors take the skills necessary to help companies congregate the necessities of the law
Nature of internal audit activity
Based on a risk evaluation of the organization, internal auditors, management and failure to notice Boards resolve where to spotlight internal auditing hard work. Internal auditing activity is usually conducted as one or more isolated projects. A representative internal audit project [7] involves the following steps:
Establish and converse the scope and objectives for the audit to suitable management.
Develop and considerate of the business area under evaluation. This includes objectives, capacity, and key operation types. This involves review of documents and interviews. Flowcharts and narratives may be produced if required.
Explain the key risks opposite the business activities within the scope of the audit.
Identify control events used to make sure each key risk and operation type is correctly restricted and monitored.
Develop and implement a risk-based example and difficult approach to conclude whether the most significant controls are operating as projected.
Report problems recognized and consult action plans with management to talk to the problems.
Follow-up on reported conclusion at proper intervals. Internal audit departments continue a follow-up record for this reason.
Project duration varies based on the difficulty of the activity being audited and Internal Audit possessions presented. Many of the above steps are iterative and may not all occur in the progression indicated.
By analyzing and recommending business improvements in critical areas, auditors help the organization meet its objectives. In addition to assessing business processes, specialists called Information Technology (IT) Auditors review information technology controls.
Cost & benefit of internal audit
Internal audit can be helpful to most organizations because, if designed correctly, it provides management with a style to recognize those risks that may avoid the organization from meeting its objectives. For example, if a company has a planned objective to elevate $20 million in loans to build a new facility there are a number of risks that may prevent that from occurring. One risk may be the external factor of increased interest rates. Another risk may be internal risk that management does not qualify for credit because of covenants they will not be able to meet.
Financial costs of internal audit will vary based upon the size and goal of the internal audit function. Additionally, the cost will be based upon the resources used to perform the work (outsource, co-source, in-house). The most significant non-financial cost may be a negative reputation of the internal audit role throughout the organization. If the function is not properly established, socialized and executed then the validity of the function could be jeopardized.
Benefit of internal audit
Proper accounting system
Better management
Progress review
Effective control
Assert protection
Division of works
No errors
Fixing responsibility
Help external auditing
No fraud
Performance improve
Proper use of resources
Investigation
Suggestion
OBJECTIVES AND SCOPE OF INTERNAL AUDIT
Internal audit is and self-governing assessment function established by the management of an organisation for the review of the internal control system as a service to the organisation. It separately examines, evaluates and reports on the sufficiency of internal control as a involvement to the correct, economic and successful use of resources
Scope of internal auditing
The possibility of internal auditing currently embraces wider concepts of community governance: risk and power – recognizing that organize exists within an organization basically to manage risk and advance valuable governance  . The most significant vary is that the internal auditors are estimated to modify their mindset: from faultfinders to advisors. Internal auditors should take care of the
auditee as their consumer. As with a client, the internal auditor should obviously communicate with the auditee, engage management in the audit development process, consider organizational risks that are prospective areas of audit anxiety, work with managers to find suitable solutions, discuss conclusion before officially reporting, and seek suggestions from the auditee for the development of audit practice. Some organizations with broad-scope internal auditing is in progress using internal audit as a exercise ground for their prospective managers, as it provides a bird’s eye too analysis of the entire organization. Internal auditing has become a profession in its own right, with a body of comprehension, professional qualifications, code of ethics, self-sufficient career progression and a system of quality secure.
Much of the development in internal auditing has taken place in the private sector. However, the public sector has also started realizing the importance of this function. The public sector has seen several waves of thought. Soon after the World War II, the rebuilding of war torn economies and developing the de-colonized countries became the most important priority. Everyone was enthusiastic about planning, import substitution and fixed exchange rate. The theory worked well for a few years when it started showing constraints. The challenge of socialism and the cold war concerns gave birth to large-scale nationalizations around the globe. The size of Government started bulging. The public sector became quite large. This gave birth to the realization that the public sector must perform in an environment of economy, efficiency and effectiveness. Demands for performance measurement, and value-for-money became prominent. While there was a level of dissatisfaction with the frameworks for performance measurement and value for money auditing that governments had in place, these concerns about the efficiency and effectiveness of the public sector remained vexing and generally were not addressed in any substantive way until a wave of privatization engulfed the entire world. The privatization led to demands for proper regulation of the newly emerging privatized enterprises. Along with this came a whole host of concerns for good governance, transparency and accountability of the public sector from a much broader and more influential range of stakeholders.
Objectivity of the internal auditor
Each internal auditor should have and purpose manner of mind and be in a sufficiently autonomous position to be able to implement judgement, express opinions and present recommendations with impartiality.
(a) The internal auditor, although his employment by the organisation, should be free from any difference of attention arising either from professional or personal relationships or from pecuniary or other interests in an organisation or activity which is subject to audit.
(b) The internal auditor should be free from undue influences which either restrict or modify the scope or conduct of his work or over-rule or significantly affect judgement as to the content of the internal audit report.
(c) The internal auditor should not allow his objectivity to be impaired when auditing an activity for which he has had authority or responsibility.
(d) An internal auditor should be consulted about significant proposed changes in the internal control system and the implementation of new systems and make recommendations on the standards of control to be applied. This need not prejudice the auditor’s objectivity in reviewing those systems subsequently.
(e) An internal auditor should not normally undertake non-audit duties but where he does so, exceptionally, he should ensure that management understands that he is not then functioning as an internal auditor.
Internal audit functions in an organization?
Internal audit is one of the internal control procedures that are to be followed by the various departments and employees of the organization. The objectives and scope of internal audit cover the following:
Verification of compliance with established policies.
-Verification of the effective operation of established systems and other controls.
-Verification of both fixed and current assets of the organization.
-Based on the above findings, suggest improvements in the system controls in order to plug the loopholes.
An internal audit manual indicating the scope of verification of each functional area within the organization is necessary so that the responsibility entrusted to the internal audit department is clear to the functional departments and external auditors also. Whether the controls as aforesaid are operating normally without breakdown of any system is to be observed by internal auditor. In judging the adequacy or otherwise of the internal audit functions
Internal audit procedure
1. PURPOSE
The purpose of this process is to ensure that both an initial internal audit and follow-up internal audits are carried out in accordance with ISO9002.
2. SCOPE
This procedure covers the performance of regular internal audits which are to be carried out on all procedures as listed under the Quality Management System.
3. COMPLIANCE
This procedure is written in compliance with ISO9002 clause 4.17.
4. DEFINITIONS
4.1 INTERNAL AUDITOR: A delegated staff member who has undertaken an internal auditing workshop conducted within the department.
4.2 INTERNAL AUDIT: An audit to be carried out by an internal auditor who is independent of the procedure being audited. To be carried out on a regular basis to verify the effectiveness of the procedure in accordance to ISO9002.
4.3 AUDITEE: Staff member who is audited and who is either directly responsible for or familiar with the duties as set out by the relevant procedure which is being audited.
4.4 AUDIT SCHEDULE: Time set aside for the procedure to be audited by an internal auditor.
4.5 AUDIT REPORT: A report which confirms that an audit took place and which details the internal audit gathering. To be finished and returned to the Quality Co-Ordinator. There are four sections to this report; Part One – audit findings by the Internal Auditor, Part Two – explanation and/or recommendations. Both Part One and Two to be completed by the Internal Auditor. Part Three – auditee’s comments and actions. Part Four – comments by the Quality Co-Ordinator.
4.6 CORRECTIVE ACTION: Updating of procedures to reflect the current duties which are carried out by all the sections as listed under the Quality Management System.
 

Factors Affecting The Reliability Of Audit Report Accounting Essay

Introduction
The end of an independent audit closed with a written audit report. According to section 205 of the Companies Act 2001, the auditors shall make a report to the shareholders on the audited financial statement (FS). The objective of an audit is to render an opinion about the fairness of the client’s financial statement.
Audit report contains information value for users. Durendez Gómez-Guillamón (2003) states that audit report is found as an important element for making loan decision. Basically the audit report conveys whether the assertions made by management are credible or not.
Types of audit report.
Unmodified report
According to ISA 700, an unmodified report should be issued “when the auditors conclude that the FS are prepared, in all material respects, in accordance with the applicable financial reporting framework”.
Modified report.
However if the auditors found that the FS are not free from material misstatement based on the evidence obtained or is unable to obtain sufficient appropriate evidence to make a conclusion, the auditors should issue a modified report in accordance with ISA 705.
All qualification may arise from either disagreement or uncertainty in the scope of the audit.
Uncertainty
Uncertainty may arise from, firstly a constraint during the audit work i.e. not all records are made available to the auditors, the auditors have appointed after the inventory counts. Secondly, inability to gather evidence concerning a doubt for e.g. an accounting record that have been destroyed or lost or the directors are concealing information.
Disagreements
Disagreement is due from factual discrepancies, unsuitable accounting policies, inadequate or misleading disclosure or failure to comply with an accounting standard or legislation. Sometimes it can be resolved with the client depending on the fact.
Furthermore it is important to calculate the effect of these circumstances and this could be grouped as:
Having a material but not pervasive effect on the FS.
Having a pervasive (fundamental) effect on the FS.
‘Except for’ opinion.
An ‘except for’ opinion is given when the effect is material but not pervasive uncertainty or disagreement. An example of an uncertainty could be the part destruction of accounting record and disagreement could be the inappropriate application of depreciation policy to a particular class of fixed assets.
‘Adverse’ opinion.
An ‘adverse’ opinion is given when the matter concerned is a fundamental disagreement such as failure by the client to recognize a provision which would convert a profit into loss.
‘Disclaimer’ opinion.
A ‘disclaimer’ opinion is given in the presence of multiple fundamental uncertainties and it is impossible for the auditors to form an opinion.
Factors affecting the reliability of audit report.
Failure by auditors to issue a reliable audit report can arise from two main causes.
Auditors may identify a material misstatement and fail to report it i.e. the auditors lack independence.
Auditors may fail to detect an existing error or fraud in the financial statement.
Lack of auditors’ independence
Principles of auditors’ independence
“Independence is the main means by which the auditor demonstrates that he can perform his task in an objective manner (FEE 1995)”.
Independence is fundamental to the reliability of auditors’ reports and an indispensable component for the auditing profession. Independence has been described as “a position to take an unbiased view point in the performance of audit test, analysis of results and attestation in the audit report (Appah 2008)”. It simply means the auditor’s ability to express an honest and impartial conclusion and also the ability of reporting reality to users. In addition, independence also means the ability to resist managerial pressures that impair or are perceived to impair an auditor’s willingness to carry his work objectively and honestly.
Without independence the auditor’s opinion is suspicious and the audit is considered to be worthless. If the auditors failed to maintain independence in their work, this can affect the reliability of audit report to the sense that the auditors may have discovered material misstatement during the audit test and may deliberately ignore it and issue an unmodified opinion.
Independence: in fact and appearance
Subject to Mautz and Sharaf (1964) there are two aspects of independence:
Independence in fact (real independence) and
independence in appearance (perceived independence).
These two concepts are essential in maintaining independence. Real independence refers to the actual state of mind of the auditor. An auditor possessing the requisite state of mind will always react in the correct way as he has the ability to make independent audit decision in any compromising situation. More importantly, auditors should not only be independent in fact, but they should appear as independent in order to acquire the public trust on the auditors’ opinion. Auditors are expected to be seen as independent while examining the clients’ FS and collecting audit evidence which support their opinion (Stevenson 2002). Precisely, auditors are supposed to be independent while deciding on reporting strategies without any pressures from their clients’ management (Cullinan, 2004). Church and Zhang (2002) argue that independence in fact ensures the reliability of audited financial statements and independence in appearance helps to promote public confidence which will automatically increase the trust of the users on audited FS.

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Factors affecting auditors independence
Size of Audit Firm
Various studies have proven that larger audit firms are more able to resist managerial pressures i.e. higher auditor’s independence (Gul 1989, Abu Bakar et al. 2005, Alleyne et al. 2006). Small audit firms may impair independence because they have a tendency to provide a more personalized service to their audit clients which will ultimately develop a close relationship between them (Shockley 1981). Since big firms have many clients, they are not affected by their client’s fees so they have less incentive to report favorably to their clients. Moreover, DeAngelo (1981) reported that large audit firms are more likely to issue reliable report since they fear of losing their reputation if they are found to be associated with accounting scandals. However there is no assurance that larger firms are more able to resist pressures from their clients as pointed by Goldman & Barlev (1974) due to the fact of the case which happened with Arthur Andersen and Enron.
Level of Competition in the Audit Services Market
Competition within the audit market is a major factor affecting auditors’ independence (Sucher and Bychkova 2001; Umar and Anandarajan 2004; MacLullich and Sucher 2005). High level competition compel the auditors to tolerate managerial pressures and ignore any material misstatement detected during the audit test and issue incorrect report as they fear of losing the clients due to the fact that the same services are easily available elsewhere. However, Gul (1989) argued that the level of competition do not cause auditors to be less independent. The existence of competition create a fear in the mind of the auditors as this same services are easily available in the market so they will strive to create a good image of themselves and increase their independency in order to maintain their clients and attract new ones.
Tenure of an Audit Firm Serving the Needs of a Given Client
An audit firm’s tenure is the length of time it has served the audit needs of a particular client. Most researchers have viewed tenure as a factor which affects the auditors’ independence negatively (Abu Bakar et al., 2005; Alleynes et al., 2006). Tenure may result into friendship with the audit client and make the auditor to ignore imperfections that have a significant material impact on the FS (Moore et al. 2006). Mautz & Sharaf (1961) emphasized that a long tenure creates complacency, lack of innovation, less rigorous audit procedures and a learned confidence between the audit firm and the clients. It may happen that the audit client has changed the business activities but the auditors are still using the same old audit procedures. Ongoing relations make the auditors to rely upon last years’ auditing and prevent them from making new evaluation of the control system, thus affecting the reliability of audit report.
Size of Audit Fees Received by Audit Firm (in relation to total percentage of audit revenue)
Large size of audit fees caused a higher risk of losing auditors’ independence. “The IFAC’s Code of Ethics for Professional Accountants (1996, para 8.7) suggest that client size (measured from size of fees) could raise doubts as to independence”. Since audit firms depend on fees for their survival, a step such as qualifying the audit report could be ignored so as not to displease the client and also for the fear of losing income. It is exclusively relevant if the audit firm receive a major proportion of its fee revenue from a particular client. Conversely Pany & Reckers (1983) argued that the large size of the client’s audit fee (measured as a percentage of office revenues to the audit firm) do not show any significant impacts on AI but it inclined the public to be less confidence in the auditor’s independence.
Non-audit services (NAS)
The provision of NAS such as book-keeping and financial statement preparation services, internal audit services, taxation and legal services to audit client is regarded as a potential factor which affects auditors’ independence drastically. Wines (1994) found out that auditors receiving NAS fees are less likely to qualify their opinion than auditors that don’t receive such fees. The NAS fees make auditors financially dependent on their clients and less willing to restraint managerial pressure for the fear of losing their business. “Brandon et al (2004) found that auditors would not perform their audit services objectively and joint provision would impair perceived independence”. Joint provisions help the auditors to be in a better position in concealing any material facts since they will the same person who will prepare the FS and the same one who will perform the audit. Moreover as the level of clients’ pressures increased, the auditors became less concerned on the quality of internal control system (Muhamad and Karbhari, 2006), thus affecting the quality of audit report since these internal deficiencies will remain concealed.
Failure by auditors to detect material misstatement in the financial statement.
The second factors affecting the reliability of audit report is failure by auditors to detect an existing fraud or error in the FS. Very often, when material misstatement is discovered, the board members are surprised by the occurrence and even more surprised by the fact that the auditors did not detect it. Failure by auditors to detect an existing fraud or error during the audit is costly to their firms because they suffer damages for giving an incorrect audit opinion and at the same time affect the audit quality. Material misstatement has increased considerably over the recent years and professionals believe this trend is likely to continue.
ISA 240 The Auditor’s Responsibilities relating to Fraud in an Audit of Financial Statement states that misstatements in the FS can arise from either fraud or error.
Error is an unintentional misstatement in FS, compromising the omission of an amount or a disclosure, such as a mistake in gathering or processing data, an incorrect accounting estimate and a mistake in the application of accounting principles.
“The ISA 240 refers fraud as an intentional act by one or more individuals among management, those charged with governance, employees, or third parties, involving the use of deception to obtain an unjust or illegal advantage”. “Aderibigbe and Dada (2007) define fraud as a deliberate deceit planned and executed with the intent to deprive another person of his property or rights directly or indirectly, regardless of whether the perpetrator benefits from his/her actions”.
According to ISA 240, there are two types of fraud namely:
misstatements resulting from fraudulent financial reporting (management fraud) and
misstatements resulting from misappropriation of assets (employee fraud)
“Fraudulent financial reporting (FFR) involves intentional misstatements or omissions of amounts or disclosures in FS to deceive FS users”. Some types of FFR include manipulation, falsification or alteration of accounting records, misrepresentation or intentional omission of events, transactions or other significant information and intentional misapplication of accounting principles relating to measurement, recognition, classification, presentation or disclosure.
Misappropriation of assets involves the theft of an entity’s assets such as embezzling receipts, stealing physical or intangible assets and making the organization to pay for goods and services not received. Such acts are often accompanied by false or misleading records or documents in order to conceal the fact.
Responsibilities of the auditors
Various studies that have been conducted in different countries showed that many users perceived that it is the responsibility of the auditors to detect irregularities (Leung and Chau. 2001 in Hong Kong; Dixon et al (2006) in Egypt; Fadzly and Ahmad. 2004 in Malaysia). Since the fall of Enron, Boynton et al (2005) argue that auditing standards have been revised to re consider the auditors’ responsibilities regarding fraud.
Moreover ISA 315 requires the auditors to evaluate the effectiveness of the client’s internal control system in detecting or preventing material misstatement occurring. Boynton et al (2005) emphasized that this condition was not previously needed, such an evaluation was only required if the auditors chose to rely on the internal control system in attempt to lessen the extent of the audit procedures. All staff members are required to communicate their result in order to combine the minor irregularities detected by each of them and required to consider the incentives and opportunities existed in the organization that induce the occurrence of fraud.
An auditor who is conducting an audit in accordance with ISA’s should obtain reasonable assurance that the FS taken as a whole are free from material misstatement whether from error and fraud. But an auditor cannot provide absolute assurance that the FS are free from material misstatement since some material misstatements of the FS may not be detected, even though the audit is properly planned and performed in accordance with the ISAs.
Furthermore frauds are more difficult to detect than errors since the former involve the use of sophisticated and well organized plan to conceal them. It should be noted that management fraud is more difficult to detect than employee fraud as management is often found on the higher position and is more able to directly or indirectly manipulate figures. Such attempts may be even more difficult to detect if they are accompanied with collusion because collusion may cause the auditor to believe that audit evidence is persuasive when in fact, it is false.
It is worth to note that the ultimate responsibility in relation to fraud detection and prevention rest with those charged with the governance of the entity and management. It is their responsibility to implement appropriate internal control systems to prevent fraud in their companies.
Factors affecting the ability of auditors to detect material misstatement.
Poor audit planning
Planning is critical to the effectiveness and efficiency of an audit engagement (Mock & Wright, 1992). It can be concluded that information obtained in the planning stage have an impact on the subsequent audit procedures and the audit evidence to be evaluated (Joyce, 1976). The planning stage consists of materiality assessments, risk assessments and decision on the kind of evidence to be collected.
If the initial risk assessment is wrong, the planned audit procedures may be incorrect or insufficient, thus reducing the reliability of the FS and increase the auditor’s exposure to lawsuit and unfavorable outcomes (Palmrose 1987).
If the auditors fail to assess risk, a material error could arises in the raw data of an account balance (inherent risk (IR)), passes through the internal control system of the entity undetected (control risk (CR)) and escapes detection by the auditors’ tests and procedures (detection risk (DR)). The risk assessment stage is vital as it enables the auditors to identify areas where there is a high probation of material misstatement, plan audit work that address those errors and minimize the chance of giving an incorrect audit opinion. The risk assessment comprises of three important elements namely IR, CR and DR. If any of these three elements are wrongly assessed, it affects the subsequent procedures and many misstatements would go undetected. IR is important as it identifies risks which are inherent within the industry. CR enable auditors to assess whether the client’s internal control system can identify or prevent any material misstatement occurring. The assessment of inherent and control risk will have an impact on detection risk as they will determine the extent of audit procedures.
Furthermore, if the auditors fail to determine materiality level, this can cause many material misstatements or omissions go undetected. IASB defined materiality as “information is material if its omission or misstatement could influence the economic decision of users taken on the basis of the financial statement”. Determining materiality is a matter of professional judgment. It can be concluded that both materiality and risk assessment contribute to determine the nature, extent and timing of audit procedures.
Inexperienced Auditors
Although a successful audit depends on a good planning stage, the ultimate success depends on the auditors’ experience to conduct the audit. Experienced auditors have the appropriate and adequate skills required in order to achieve audit objectives to the satisfaction of the client.
Very often, auditors fail to detect material misstatement despite having assessing a high initial risk assessment, the reason behind this failure is that they lack the required skill to perform the audit while simultaneously identifying relevant risk factor. Experienced auditors is regarded as an valuable asset to the audit firm since they have more practice and feedback on the types of material misstatement that could be existed in the FS and its rate of occurrence (Libby and Frederick, 1990), thus increasing the likelihood of detecting potential fraud more easily. Bedard and Graham (2002) concluded that auditors with more experience with a particular client industry have more ability to identify risk factors than auditors with little or no experience with that industry.
Furthermore, Moeckel (1991) found that experienced auditors search for more evidence than less experienced auditors. It simply means that experienced auditor do not only rely upon the evidence produced by the client but they look for further relevant and reliable evidence outside the entity before reaching an opinion, thus increasing the chance of detecting irregularities. Libby and Trotman (1993) found that senior auditors have the ability to recognize evidences which are inconsistent with their judgment.
Time budget
Time budget is considered as a major problem faced by almost auditors. Time budget pressures affect the quality of an audit as it prevents the auditors from allocating adequate number of time to complete specified audit procedures (Margheim, Kelley & Pattison, 2005) and limits auditors’ ability to expand the extent of audit test (Asare et al. 2000), thus affecting the ability of auditors to detect material misstatement in the FS. It is worth to note that when attainment of budget is considered as a major factor in performance evaluation, auditors are more likely to engage in dysfunctional behaviors such as reduction of follow-up procedures, underreporting of time, and overriding auditing procedures in the work program (Azad 1994).
Time pressures create a stressful working environment among the audit team which is likely to affect the ability of auditors to detect material misstatement since the auditors tend to behave unprofessionally. This includes behavior such as superficial examination of documents, acceptance of weak explanations by the client, reduction of work on an audit step below acceptable levels. E.Cook and Kelley (1988) survey results’ showed that auditors are more likely to engage in reduced audit quality practices in order to attain the time set by the firms. It simply means as time budget pressure increased, the auditors’ performance decreased significantly (McDaniel, 1990).
However, time budget make auditors work harder and charge all time properly (Kelley and Seiler1982, Cook and Kelley 1991, Otley and Pierce 1996a). Moreover time budget is likely to enhance audit judgment by encouraging auditors to emphasis more on relevant information thus preventing them from being influenced by irrelevant information (Glover 1997).
Sampling error
According to ISA 530 “Audit Sampling and Other Sampling Testing Procedures, audit sampling involves the application of audit procedures to less than 100% of items within a population of audit relevance such that all sampling units have a chance of selection in order to provide the auditor with a reasonable basis on which to draw conclusions about the entire population”.
Every audit involves the use of sampling since it is costly for the auditors to examine 100% of all the transactions that took place during a period. The auditors use some form of audit sampling to test the internal control system, help them to reach a conclusion about whether or not material misstatement exist.
But sampling always involves some risk, i.e. the auditors might not look at enough items or the sample result might not be representatives. This can have a drastic effect since the auditors might reach an incorrect conclusion. Sampling risk could occur in both test of control and substantive procedures. In test of control, there is the risk of assessing control risk too high or too low.  Assessing control risk too high result into audit inefficiency and assessing control risk too low makes the auditor rely on ineffective control procedures which increases detection risk. In substantive procedures, there is the risk of incorrect acceptance and risk of incorrect rejection. Incorrect acceptance is the risk that the conclusion drawn from the audit sample is that the account balance is not materially misstated, when in fact it is materially misstated. Incorrect rejection is the risk that the conclusion drawn from the audit sample is that the account balance is materially misstates, when in reality it is not.
Inadequate audit fees
There is limited empirical evidence on the linkage between low audit fees and audit quality. However we can say that audit fees have an impact in the performance of auditors. Numerous Accountancy members have noted that low fees are associated with inadequate audit work. For example, an auditor might use his judgment to the client rather than devote additional time to investigating an audit issue and search for reliable evidence. This would likely to make the auditors to fail in identifying a material misstatement in the FS and issue an incorrect opinion.
It can be asserted that when audit fees are abnormally low, the concern is poor audit quality as the auditor might attempt to cut back on effort to design an appropriate audit procedure that fully identify and address material misstatement.
Furthermore it can be concluded that if audit fees are low relative to the size of audit client and audit client complexity, this can cause a serious problem since the auditors would be demotivated as more time and effort would be required to perform the external audit work and to reach an unbiased conclusion, thus making the auditors to skip a lot of important audit procedures.
On the other hand, inadequate fees do not pose any concern when there is severe competition among audit firms since all audit firms will tend to tender low fees for their services in order to maintain its clients and to attract new ones.
 

The relationship between corporate governance and internal audit

Introduction
This assignment is an effort to describe the relationship between corporate governance and internal audit. But the first thing that has to be done is to understand what really corporate governance and internal audit are, and how they can be defined.
Corporate Governance cannot be defined precisely; however, there are some theories and definitions. Corporate Governance can be considered as “a field in economics that investigates how to secure / motivate efficient management of corporations by the use of incentive mechanisms, such as contracts, organizational designs and legislation”. But, it is often limited in how financial performance can be improved. For example, how the company’s owners can secure that the managers will deliver a positive rate of return (Mathiesen 2002, cited in www.encycogov.com). Another theory defines the corporate governance as the way of how firm and organizations can be managed and controlled (OCED 1999).

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Moreover, companies select the managers in order to be accountable and trustworthy to the shareholders. However, sometimes the interests of the two sides are controversial and can diverge. For instance, managers want to increase the market share and on the contrary, shareholders wish to exploit the Firm’s value. Obviously, there is a confliction between the two sides. The intention of Corporate Governance is to resolve this confliction in order effectiveness and profitability can be achieved. (Tirole 2001; Berle & Means 1932; Shleifer & Vishny 1997)
Corporate governance is consisted of three main pillars: Management, Board of Directors and the External auditor. However, internal audit is supposed to be the fourth. Internal audit can be defined as an autonomous assurance and consulting method that has been created in order to increase value and improve company’s operations. Moreover, aids the company to achieve its goals by using a systematic and disciplined methodology to estimate and increase the efficiency of governance, control and risk management procedures (KPMG, 2007; Rezaee, 2002).
Internal audit
Internal audit and internal control should not be confused each other because they are two totally different meaning.
Moreover, internal control is a procedure, caused by a company’s board of directors and management, which is established to deliver realistic assurance regarding the accomplishment of company’s goals in the succeeding categories:
Effectiveness and efficiency of operations.
Reliability of financial reporting.
Compliance with applicable laws and regulations.
Moreover, internal control’s purpose at organizational level is to: ensure the reliability of the provided financial reports, to give a suitable feedback on the accomplishment of company’s strategic or operational objectives, and to assure that company complies with regulations and legislation. At transactional level, internal control refers to the activities that company has been made in order to accomplish particular objectives such as payments to third parties. Additionally, internal control has significant role in averting and perceiving fraud and also in protecting company’s assets, both tangible and intangible. (Cattrysse, 2005; KPMG, 2008).
On the other hand, as it was referred before, internal audit aids the company to attain its goals by using specific methodologies to estimate and upsurge the efficiency of governance, control and risk management and has been created in order to increase value and improve company’s operations. As it could be easily understood internal audit’s role is very significant not only for the Board of Directors but for the External Auditors and the Audit Committee too. (Deloitte, 2009; KPMG, 2007)
Nevertheless, except from its controlling and supporting operations, it can also be referred as consultative, because can provide information of prospective flaws of the company both in business and financial level. Furthermore, the Board of Directors through internal audit can be informed about the company’s internal control function (KPMG, 2007).
To continue with, the main objectives of the internal audit are:
Define the crucial risks that the company’s activities cope within the scope of the audit
Establishment and implementation of a risk-based testing method to examine if the most important controls are functioning properly
Identifying and reporting problems to the management and suggest actions to address them
Investigate and evaluate every operational and financial information
Examine and evaluate internal control system and framework
Analyze in depth every financial statement, in order to examine: a) whether the company operates effectively b) and if its objectives have been achieved (Morariu, A., 2009)
The above objectives can vary and some of them may not take place, because of many factors such as: company’s nature, complexity of the activity being audited and the available resources. Moreover, auditors could support the company to achieve its objectives by evaluating and recommending possible improvements in critical areas. But, all these benefits of the internal audit cannot be trustworthy when the auditor is from company’s internal environment and not independent. Auditor could lose his integrity if he deals with daily processes that are being audited. (Morariu, A., 2009; KPMG, 2007)
The role of Internal Audit Unit, Audit Committee and External Auditor
Internal Audit Unit is a vital part of the company. It is established by top management executives who are qualified and trained to suggest corrective actions when a problem occurs. It has an independent purpose and it is directly committed to the administration of the company. The reasons that exists are numerous but the majors are the succeeding:
To describe the company’s control type
To determine unprejudiced risk assessment,
To indicate the several procedure forms of the company
To present the compliance framework,
To demonstrate and examine both the financial and the operational performance
To make recommendations for maximizing the usage of the available resources
To evaluate if the desired objectives have been achieved
To be responsible for feed backing about company’s ethics and values (Hermanson & Rittenberg, 2003; KPMG, 2008).
Additionally, the role of the internal audit in the company is mainly based on the company’s size. The higher the company is the higher the role the internal audit is and the higher its responsibilities are. Moreover, the formation of the internal audit committee depends on one main factor, whether the company is listed in Stock Exchange or not. Whether the company is listed in the stock exchange, internal audit could be more efficient as the only person in charge is the CEO. Contrariwise, whether the company is listed, the internal audit has to be supervised by the Audit Committee (Hermalin B. & Michael W., 2001).
Audit Committee is in charge of monitoring and supervising disclosure and financial reporting. Its members are selected from the Board of Directors of the company, and the chairperson is selected amongst the members of the Audit Committee. Moreover, Audit Committees are authorized to obtain the consulting resources and the knowledge which are considered to be required in order to execute their responsibilities efficiently. Their responsibilities are:
Monitoring the financial reporting and the disclosure procedure
Overseeing accounting principles and policies
Controlling the internal control progression
Supervising the performance of external and internal auditors
Overseeing the risk management policies and suggests improvements to company’s management
(Hermanson & Rittenberg, 2003; McMullen D.A. & Raghunandan K. 1996; AICPA Committee On Auditing Procedures)
External auditing is very significant process for the appropriate corporate governance which is being made from independent qualified professionals. Moreover, the external auditor executes an audit, according to particular laws and principles, on the financial statements of the company. As the auditor is completely independent of the companies or entities being audited, his financial information reports are unbiased and also reliable for the investors and government agencies. Moreover, the audit reports are of significant use for the company because are focused mainly on company’s financial results and performance and examines management issues in order to avoid probable risks (Pop et al., 2008; Ojo, M., 2009).
However, it is compulsory for the external auditors to be member of one recognized accountancy bodies and of course their qualifications, their format of reporting are defined by the state and sometimes may differ from country to country. (Omega Accountancy Company).
Internal Audit and Corporate Governance
The role of internal audit in implementation of the Corporate Governance principles is very crucial. Moreover, internal audit -always based on consistency, accountability and transparency- records and examines the internal processes in practice, presents the weaknesses in the system and propose corrective actions and adjustments. The main objective of internal control is to establish a strong connection between managers and divisions of the company and to force company to adapt its existing institutional framework (Allen S., 2008).
The internal audit can be characterized as a mechanism for overseeing the operation of principles of corporate governance and for ensuring the shareholders’ interests. Additionally, the internal audit management examines whether the company’s activities operate properly, without been limited only in financial and accounting activities, or not (Baker C.R. & Owsen D.M., 2002)
The importance of the internal audit and the audit committee was understood early and for that reason Corporate Governance regulations and recommendations have been created and adopted by all countries.
In 1992 Cadbury Report was established to make some adjustment to the existing framework by introducing new principles such as integrity, accountability and openness. Cadbury Report was mainly focused on separating the role of CEO and the chairman. Briefly the main points were:
Audit Committee should be staffed by at least three non-executive directors
Every contract should expire after three years
Non-executive directors should be independent from management and must be unrestricted from other responsibilities or companies (Cadbury A., 1992; Cattrysse, 2005)
However, despite the fact that Cadbury’s report regulations were applied internationally, some major corporate scandals occurred such as Enron and WorldCom. For this reason, the US Government was enforced to establish in 2002 the Sarbanes-Oxley Act (SOX) in order to prevent another fraud. Moreover, SOX included 11 sections with regulations which are focused mainly on corporate responsibility, auditor’s independence and corporate fraud accountability. The section 404 of the act makes recommendations for internal auditing (Sarbanes-Oxley Act, 2002; Gillan, S., 2007)
Sarbanes-Oxley Act states that internal audit should: consult on the company’s existing internal control and suggest adjustments if needed examine and support the role of the management when it creates stress tests to evaluate the efficiency of the internal control and help in the educational and training part of the internal control. Additionally, it refers that management should only supervise if the internal control’s processes are applied on financial reporting (Deloitte, 2009).
In 2010 Combined Code has been established by the Financial Reporting Council to enhance the role of Corporate Governance. This Code is a combination between Cadbury’s, Greenbury’s and Hampel’s Report and it is focused on the corporation performance, accountability and prosperity. Moreover, the Combined Code:
Includes risk averting principles
Give to the non-executive directors new responsibilities related on strategic issues
Enforces the shareholders of all the listed companies to re-elect annually the directors
Established a principle that forces all the executives to be cognizant of their major shareholders (Combined Code, 2010).
Corporate Scandals
In past decades major corporate scandals have been recorded and finally lead to the financial crisis of 2007-2009.The most significant are Enron, WorldCom and Lehman Brothers.
Enron was established in 1985 as a natural gas company. In 1999 the company transformed into a leading company in gas, electricity and oil with a stock value reaching $45 per share. In 2000 it stock value reached in $91 per share. In 2001, Sherron Watkins, who was the president of the company, decided to write a letter anonymously to the CEO of the company Ken Lay. Watkins informed him that company was dealing major problems with its alliances regarding the audit part of them, the role of the CFO in them and the probable negative impact on the market if all these information were published.
Meanwhile, the company’s traded shares worth approximately about $ 41 million. Also, other members of the company traded $ 71 million in shares. The value of the share dramatically decreased to $28, after the terrorist attack of September 11. One month later the company announced $618 million loss in the third trimester, $1.2 billion considering the aforementioned reports (Gudikunst A., 2002).
As it can be easily understood, the main reasons that led Enron in bankruptcy were the inadequate internal audit, the CFO’s exorbitant salaries and the inability of CEO to administrate his own company efficiently.
Moreover, another worth-mentioning case of bankruptcy is WorldCom. The main problems were:
Bad cash management – cash flows manipulation
Operating expenses were treated as Capital Investment
Weak internal Control
Questionable Ethics (Gillan, S. 2006)
Conclusion
As it was mentioned, Internal Audit Unit, Audit Committee and the External Auditor were some supervising authorities which have been established in order to help companies to work more efficiently and to improve their performance. Additionally, Cadbury Committee Report, Sarbanes-Oxley Act and the Combined Code 2010 were created for better Corporate Governance practices and to limit companies’ activities, prevent frauds and to protect the investors- Something that seems to go well-.
However, despite the harsh regulation and the supervising of the authorities some companies succeed in overcoming the existed legislation and committed major corporate scandals and frauds.
As it can be understood, regardless of how many reports, legislations will be created, companies will find again ways to overcome them and commit financial crimes. Because the main problems is not the framework of internal audit or the efficient implementation of the corporate governance’s principles but the deontology, corporate culture and the ethics that the companies have. These are the first things that should be corrected and all the others are of minor importance.
 

Accounting Audit: Case Study

The inventory valuation is done on cost basis, while the NRV (Net realizable value) is 10% below the cost. As per the accounting standards in Australia governed by the AASB, the inventory valuation is done based on the basis of lower of cost or realizable value, whichever is lower, which is as per the guidelines laid down under the provisions of AASB 102.

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However, since the cost is of higher value in comparison to the realizable value, the system followed here reflects the inventory at higher value, which is not the fair value of inventory and contravenes AASB 102. This is the just and fair opinion of independent auditor. In view of this, the audit opinion expressed is fully justified. The inventory should reflect the fair value of the inventory and the cost basis does not reflect the fair value of the inventory as per acceptable accounting principles. Hence the system of accounting followed should be subjected to fair audit, and corrective measures should be taken for rectification. Further, the opinion expressed by the auditor should be an adverse opinion, since the accounting systems and practices followed by the company contravenes the principles and concepts of accounting and the provisions as per AASB and the Corporations Act, 2001 given the materiality of the information and facts reported by the company and the fairness in the reporting of the financial statements.
The client has entered into a real estate contract of purchasing some property and developing shopping complex, and further selling the same to an unrelated third party at a “profit-based” (cost-plus) basis of settlement price. As the real estate markets fell and the rates had dropped, the purchaser sued the client on the basis that as he relied on markets and rates forecasted by the client, he was not getting the forecasted prices in the market because of recessionary conditions in the market.
In view of the uncontrollable market conditions resulted due to no fault of the client, the auditor opined that the client need not pay any damages as he is not liable for any loss due to uncontrollable factors in the market over which client has no control. In view of this, the opinion of the auditor is just and fair. Moreover, when the transaction that has taken place between the purchaser and the client, the client is supposed to have information about the risks such transactions are exposed to. The market risk is covered under AASB7, which deals with the various risks arising under financial transactions. In view of the above, the auditor’s opinion with regard to client liability for loss is fair and fully justified. However, sensitivity analysis has to be conducted with respect to the variable parameters and the methods followed for the sensitivity analysis. The impact of the price analysis or forecasting is studied on the basis of the changes in these variables. In this case, as the client is not part of the final transaction pertaining to the sale after the completion of the deal, the client and its management is not liable. The entire risk in this case is to be borne by the purchaser himself who has to bear the entire market risk. Market risks are not part of any deal between parties. Hence, the auditor’s opinion that the client is not liable for the damages legally is fair and correct. Moreover, since there is always the probability of (market) risk involved due to price fluctuations, it is the presence of market forces which could have gone either way.
The probability of loss to the client in the event of the markets falling could not be underestimated. Hence, the opinion here of the auditor should be a disclaimer opinion (a category of Qualified opinion) since the best forecast of the estimates could go wrong and hit either side and the auditor could not be held liable for the estimation or forecasting based on market factors (external), given the information and facts available to the auditor for forming an opinion about the company’s accounting policy.
(iii)
In this case, there is a small NFP or Not-for-profit organization, which can be characterized by a high % (completion) of total revenue and, in such a organizational framework, the internal control degree is low. In view of this, the % completeness of revenues and the risks associated with auditing are also high. Larger the size of the NFP organization, lower the completion % of total revenue and better control over internal control and in turn, lower the risks associated with
As the degree of internal controls is low, the auditor’s assertion of poor audit evidence and lack of control over the revenue completeness is correct and fair. Hence, the opinion issued by the auditor is one of disclaimer type in view of the limited scope or horizon and the limitations of the auditor in terms of the audit evidence provided or made available to the auditor to give the fair and independent opinion and the materiality of the information given. So there is a limitation of scope of the auditor’s examination.
(iv)
The company is follows the accounting policy of not disclosing the director’s fees in its financial reports.
Since the disclosure of director’s fees is mandatory as per Corporations Act, 2001, (Australian corporation and securities legislation, 2001), the assertion and opinion of the auditor with regard to the materiality or otherwise of the fees does not hold well. The Materiality arises when it affects (i) decision making with regard to resource allocation (ii) accountability of management. The point of materiality is covered under AASB 1031 of the Australian Accounting Standards Board. Since as per the Govt. of Australia’s guidelines issued with respect to disclosure of director’s fees is mandatory, non-compliance with the same or non-disclosure may lead to penalties for non-compliance on the part of the management and the auditors of the violating company. Hence, in view of contravention and non-compliance with the acceptable financial reporting policies, the auditor needs to give a qualified report.
(v)
The management of the company estimates the provision for bad debts at $550000. The audit arrives at the fair and reasonable estimate at 655000. The management of the company has refused to accept the figures of estimated given by the company for it would reduce the ne profit to the extent of $105000. Bad and doubtful debts are classified into recoverable and irrecoverable debts. Under the accounting norms for bad debts as per the Corporations Act, 2001, the irrecoverable debts are written off. The recoverable debts are those which are likely to be recovered and provision in respect of which is make in the financial statements of the year. Provision for Doubtful debts is under Section 237 of the Corporations Act, 2001 and AASB 124. In the Income Statement, the provision for doubtful debts is shown as a loss, while in the Balance Sheet, the provision is reduced from the Trade debtors as Net Debtors and is shown under current liability on its own (Current liabilities and provisions). Audit of accounting estimation follows the procedure – collection of audit evidence, ascertaining and assessing the reasonability or otherwise of the accounting estimates, revising and renewing the estimates, and reviewing the subsequent events. As the materiality factor is involved in the accounting for the estimated figure of provision for doubtful debts, the report would not give a fair view of the financial report for the period and hence the auditor should give an adverse report indicating that the accounts do not reflect fairness in its state of affairs and financial position.
(vi)
In the case, the company has cash balances maintained in a foreign bank account situated in a foreign country or location.
In this case, since there is no substantial audit evidence to enable the auditor to form an unbiased, independent opinion, the auditor can only give a subjective, qualified (limited scope) opinion on the reasonable grounds of his best professional expert judgment and experience, which may even be based on reasonable assumptions born out of facts available. Since the materiality figure is given, and the cash balance in the foreign account is just close to that figure, quantitative figures of materiality in the case do not hold good. Hence, the classification by the auditor of the entire cash balance held in the foreign account in the foreign location as current asset (asset required to meet short term obligation) is fully justified and the opinion given by him would be classified as disclaimer opinion, since the opinion does only reflect the best under the given circumstances and the facts.
PART- B
Introduction
The auditor gives opinion of three types, in case of audit reports, namely, adverse, disclaimer, and qualified opinion in respect of the company’s accounting norms, procedure and systems. Further, the audit of accounting estimates of the company’s accounting procedure and practices would be generating modified, unqualified and qualified audit reports
Executive Summary
Under this report, we shall locate three annual reports from the appropriate sources mentioned in respect of three Australian companies listed in the ASX (Australian Stock Exchange) and also available in the CQU website. In these audited reports, the auditor’s opinions – qualified opinions, unqualified opinions, and modified opinion with a “Matter of emphasis” as expressed by the auditors in these reports are shown. The detailed opinions are written in respect of the three companies’ annual reports considered for reporting on the “Audit analysis of the financial reports of companies”. Finally, conclusions are drawn based on the analysis of these reports.
Report
Now let us discuss the various opinions expressed by the auditors in respect of the three annual reports of the companies (Refer Appendix) as under:
QUALIFIED OPINION:
A Qualified opinion may be issued where there is a disagreement with management concerning appropriate accounting policies, a conflict between applicable financial reporting frameworks, or a limitation on the scope of the audit. A Qualified opinion can be used only when the auditor believes that the overall financial report is fairly satisfied. (Arens, at.al, 2010)
I have found the following company with the Qualified Audit opinion.
Gerard Lighting Group Ltd:
Gerard Lighting is a listed Australian Company in the power sector. As it is the major company in its product line, I have taken this company as an assignment subject so that the company’s accounting policies and practices, a strong company in the infrastructure sector can be thoroughly studied and reviewed.
The annual report of the company for Year ended 2009 has been studied and the features of its auditor’s report are as under:
Audit of its accounting estimates of expenses (Fielder, 2010) incurred during the period.
Evaluation and assessment of efficiency and adequacy of its processes and controls
Independence of the external auditor has been certified and ensured despite the auditor being engaged in the non-audit professional activities
A review of the director’s forecast (historical), historical pro-forma financial statements and best estimates assumptions, based on external factors (judgmental and subjective) beyond one’s control and scope, has been carried by the auditors, which is done as per the audit evidence and financial data available to the auditors which is insufficient for the purpose of audit, hence the auditors clearly state that this is just a review of the management activities and forecasting based on its core performance factors, not a complete full-fledged audit. Hence there is no opinion made by the auditors on the audit report in view of insufficient audit evidence with the auditor as per information provided by the company for the purpose of audit which indicates that the auditor does not undertake any responsibility and the auditor’s opinion is known as disclaimer opinion, (Arens, et. al, 2010) a classification of qualified opinion, having insufficient audit evidence to form unbiased, clear opinion.
The independent external auditor KPMG of Gerard Lighting Group Ltd has expressed their satisfaction over the financial report prepared and presented by the board of directors. The auditors have assessed and verified the statement of comprehensive income of the group, change in equity and statement of cash flow on date of year ending as well as the summary of all the significant accounting policies that has been followed by the company and the notes presented by the company. The auditors have found that the board of directors has discharged their duties in fair way. They have ensured that company follows the appropriate policies. As an overall view of the auditor this report is true, fair and free from any material misstatement.
UNQUALIFIED OPINION:
An Unqualified opinion is the most common type of auditor’s report. An unqualified opinion is issued when the independent auditor believes that the company’s financial statements are sound; that is, the statements are free from material misstatements. This is different from a qualified opinion which is issued when the independent auditor discover something in the financial statements that is subject to major concern.
Harvey Norman Holdings
This is a leading Australian listed company in the product segments – integrated retail, banking and franchise. As a company based on very sound policies, principles and practices, we have considered it for the study. The annual report of the company for the Year ended 2009 have been studied. The features of its annual report are as under:
The audit of the financial position for the year has been made as per the audit procedure and carried in terms of provisions laid down under the Corporations Act, 2010 (Australian corporation and securities legislation, 2001)and the Australian Accounting Standards Board.
The independence of the auditor being certified and ensured despite the auditor engaged in non-audit professional activities.
The compliance with the standards and opinion about the fairness of the financial position by the auditor.
Given the sufficiency of audit evidence and financial information, the audit carried represents a full and fair position of the financial standing of the company, in the opinion of the auditor with regard to the auditor’s report.
This is an unqualified report expressed with regard to the unbiased independent opinion of the auditor on the financial position of the company.
Finally, the auditor gives an unconditional, unqualified opinion based on data made available for forming an independent opinion and has classified the reports as unqualified reports
The Independent auditor Ernst and Young of Harvey Norman Holdings have found that the financial report for the year ending 30 June 2009 has been satisfactory under various rules and have expressed an unqualified opinion on the report. The auditors have found enough audit evidences from various judgments and procedures that the financial report prepared and presented by the management is true. As a whole the auditors has expressed their opinion that this financial report is true, fair and free from any material misstatements and has been prepared by complying with all the relevant rules and laws of land.
MODIFIED OPINION:
An Unqualified audit report with an emphasis of matter is appropriate for an audit with satisfactory results and a financial report that is fairly presented, but where the auditor is required to provide additional information (Arens, et. al, 2010)
The company with Modified opinion with an emphasis of matter
AXA Asia Pacific holdings:
This is a major listed Australian company in the financial (insurance) sector and is considered for the purpose of the study due to its key market position and sound financial practices. The annual report of the company for Year ended 2009 has been studied and following are the features of its auditor’s report are:
Audit of its accounting systems and procedures.
Evaluation and assessment of sufficiency of audit evidence.
Independence (Roebuuck & Martinov-Bennie, 2010) of the external auditor has been certified and ensured despite the auditor being engaged in the non-audit professional activities.
The auditor has expresses an unqualified report on the financial position and expressed compliance with the AASB1039 (Australian accounting standards board). (Audit of Accounting estimates issued by AARF on behalf of ASCPA & ICAA – AUS516, 1995)
Materiality (Pflugrath, 2010) with regard to the facts and figures presented has been checked and ascertained by the auditor and their conformance with the Australian accounting standards has been ensured. The forecast data based on judgmental assumptions and the subjective decisions made by directors of the company have not been reviewed or subjected to any kind of review. Hence, this is an aspect of a modified opinion with matter of emphasis.
Considering the adequacy of sufficient information for giving true position of the financial state of affairs of the company, unqualified opinion has been given in the auditor’s report.
The auditor Price Waterhouse Cooper has expressed their satisfaction over the independence of the external auditors and the financial reports of the AXA Asia Pacific prepared by the management under the Corporations Act 2001 and Australian accounting Standards as well as International Financial Reporting Standards. The auditors has found enough auditing evidences those indicates that this financial report of AXA Asia Pacific is true and has been complied with all the ethical and regulatory norms stated under Corporation Act 2001, Australian Accounting Standards while preparing financial reports. The auditors have said that this report is free from any material misstatement.
On overall basis the auditors have found the financial report true, fair and free of any material misstatement and has complied all the rules and laws that governs and are relevant for a corporation having business in Australia (Annual Report, 2009 AXA Asia Pacific Holdings Limited).
Conclusions
We have studied a report based on the audit opinions expressed by the auditors regarding the accounting records based on the sufficiency of the audit evidence supplied and the audit plans carried out by the auditor. In all the cases, to the extent of the information supplied, they (auditors) have made independent opinions with regard to compliance with the Accounting standards of Australia (AASB) and compliance with the Corporations Act, 2001 and have qualified their opinions to the extent of the forecast and best estimates made by the management based on their subjective judgment and perception and also made opinions with regard to the fairness of these financial reports.
From the analysis and review of the above companies, we can draw the following brief inferences with regard to Qualified, Unqualified, and Modified reports:
GLG – Qualified opinion
HRH – Unqualified opinion
AAPH- Modified opinion with matter of emphasis.
 

Roles and Strategies of a Business Audit

SUMMATIVE ASSESSMENT 2 PROJECT1

 

Write a 3,000 word paper explaining why audits are conducted and what the roles of the various audit team members (including external experts/ specialists) might be.

Explain, in detail, the procedures that would be carried out to organise, complete and report on an audit.

As part of the process, meetings will need to be held. Give examples of the types of meetings that might be held, their purpose and what might be included on the agenda of the meetings.

–          What reports might be made as a result of the audit?

–          In what format and to whom will reports be presented?

–          What legislation, codes of practice and quality standards apply to auditing?

An audit is a systematic, independent and documented process for obtaining audit evidence and evaluating it objectively to determine the extent to which audit criteria are fulfilled. 

Audit process:

Plan(planning audit activities)

 

Two types of audits may be conducted in an organisation:

               Internal:
An internal audit is performed by or at the direction of members of the organization (first party). Self-assessment and management review are conducted to ensure that the system is operating as intended; to investigate problems and implement corrective action to prevent recurrence; and to identify opportunities for improvement (processes effectiveness, efficiency, and customer satisfaction).Internal audit procedures apply to all aspects of the management system such as:

–          Standard Operating Procedures

–          Quality System Procedures

–          Environmental Management System

–          Occupational Health and Safety

–          Training procedures

–          Calibration procedures

–          Maintenance procedures

–          Emergency procedures

–          Records procedures

–          Customer complaint procedures

–          Other Specifications

Internal audits are conducted to:

–          ensure the organisation complies with all regulatory requirements

–          ensure the organisation complies with standards –  ISO 9001

–          check performance to the organization’s objectives

–          ensure the Quality Management System is effectively implemented and maintained

–          identify of problem areas

–          look for best practices and opportunities for improvement

–          search for preventive action that could be applied in the key areas

–          improve customer satisfaction

–          enhance employees satisfaction with work

–          check performance to the organization’s objectives

Internal audit is an appraisal activity established within an entity and functions under the direction of the company’s management and board. It is a management tool and forms part of the company’s internal control structure. The main focus of an internal audit is to evaluate the adequacy and effectiveness of the company’s internal control.

External

A third party conducts an external audit with a purpose of conformity to a specific standard and legislation.External audit criteria:

–          Standards ISO9001 (The global industry standard that sets out the requirements for a Quality Management System (QMS) to help organizations improve efficiency and customer satisfaction)

–          Government regulations

–          Government industry codes

–          Financial Management System

–          Corporate policies

–          Market requirements

–          Customers requirements

–          Product and services requirements

ISO9001 auditing requires auditors to use specific process auditing methods such as tracing, flowcharting and evaluating techniques align with the management system. The top management role is to determine the effective implementation and maintenance of the quality management system. Auditors play a critical role in ensuring that organisations are confident and informed when making investment decisions.

Quality management principles:

–          Process Approach in the design of the standardThe desired result is achieved more efficiently when activities and related resources are managed as a process

–          System approach to managementIdentifying, understanding, and managing interrelated processes as a system contributes to the organization’s effectiveness and efficiency in achieving its objectives

An external audit is undertaken by an auditor who is independent of the entity and has been appointed to express an opinion on the financial statements or other specified accountability matter.

Effective planning of an audit is essential to ensure that auditors focus on the areas of greater risk and carry out their audits efficiently. Generally, the audit plan consists of the following steps:

Assigning an audit representative and team to oversee the internal audit process

Defining a clear charter for the internal audit process (policies and procedures)

Implementing effective communication channels with other auditing such as finance, production process, human resources

Defining audit schedule/plan

Defining main activities and processes:

Audit criteria (e.g., what policies, procedure and instructions are required? What are internal and external requirements?)

Audit objectives (e.g., improving efficiency, improving processes, compliance with required standards such as ISO9001)

Audit scope (e.g., what are the boundaries of an audit? what processes are included? what is the audit emphasis?)

Audit  resources (e.g., who will audit? do we have personnel who has appropriate skills and knowledge? Do we need support from any special technical expertise? What support will be required?)

Relevant documentation and evidence

Defining departments and activities involved in the audit

Setting activities and timeframes

Determining the way of the input collection to management review

Determining the analysis of audit process and result (report audit results including conclusions and recommendations)

Planning corrective action (if required)

Following-up to ensure corrective actions are effective

Appointing an audit representative

An auditor is required to have knowledge and skills in:

–          audit principles, procedures and techniques

–          the organisation processes including management system, quality system, specific processes, and product or service knowledge

–          standards requirements indicated in ISO 19011 and other legislative requirements

–          education and experience

–          good judgement and communication skills

–          planning and effective communication

–          investigating and analysing situation

–          organising and directing audit team members

–          preventing and resolving conflicts and leading team in reaching conclusions

–          consolidating inputs and preparing reports

 

For the success of the audit process appointed personnel l also need to meet the auditing principles and undertake specific audit training to meet those requirements. The main principles of auditing:

–          Competence

–          Ethical conduct

–          Objectivity

–          Impartiality

–          Fair presentation

–          Evaluations based on evidence

–          Professional care

–          Independence

–          Cooperation

Audit Team Members – Roles and Responsibilities

All audit members’ internal and external, expert and specialist should share the following responsibilities:

–          Compliance with audit procedures, standards and legislation

–          Document audit findings

–          Communicate audit findings

–          Prepare a final report

–          Contribute to team effort by accomplishing related results as needed.

An audit committee plays a pivotal role in the governance framework to provide an organisation with independent oversight and monitoring of the audit processes, including the internal control activities.

The internal audit leaders are responsible for effectively managing the internal audit activity in accordance with the internal audit charter and the mandatory elements of the International Professional Practices Framework. They must ensure that internal audit resources are appropriate, sufficient, and effectively deployed to achieve the approved plan. They are also responsible for assigning areas of responsibility for each team member and identify any specialists and experts that will be needed to accompany the team in the audit process. 

Moreover, they need to for develop and maintain effective channels of communication with the key stakeholders which include:

–          Front-line employees

–          Middle management

–          Senior management

–          External auditors

–          Sourcing partners

The audit team roles and responsibilities are the same for an internal and external auditor and include a range of activities such as:

–          Planning and conducting audit

–          Attending meetings

–          Developing appropriate methodologies and objectives

–          Reviewing work processes

–          Providing ad hoc advice to managers and staff at all levels

–          Performing a risk assessment on key business activities

–          Determining appropriate levels of staffing for the audit team

–          Determining audit reporting requirements

The management responsible for the area being audited are accountable for elimination any detected nonconformities and their causes to ensure that the audit process is taken without undue delay.
 

The management and staff responsibility is to focus on the quality of reporting, timely reporting and facilitation of the audit process. They should have a positive and helpful approach to the audit process (e.g., auditors should be provided with all information and explanations that may be relevant to the audit in a timely manner)

Technical experts may be called in to provide specialist knowledge or expertise in what is being audited and to advice on technical matters that would be beyond the knowledge or capabilities of the audit team. They may accompany the team on the audit inspection if required, or be referred to when necessary. Technical experts need to be appropriately accountable for audit quality and follow the required procedures and standards.

Audit Standards and Procedures

Audit procedures indicate ways of applying techniques to a particular part of an audit, for example, the audit objectives required the collection of the data to support a decision, and how to plan and carry out internal audits.

Organisations should establish a manual of policies and procedures that guide internal auditors in their work.  The content of these policies should be consistent with relevant standards and cover the following topics:

–          Attribute Standards

–          Purpose, Authority and Responsibility

–          Independence

–          Proficiency and Due Care

–          Quality Assurance Performance Standards

–          Managing the Internal Audit Activity

–          Nature of the Work

–          Engagement Planning

–          Performing the Engagement

–          Communication of Results

–          Monitoring Progress

–          Resolution of Management’s Acceptance of Risk

 

Code of Ethics

It is a comprehensive statement of the values and principles which should be followed by auditors during the audit process. Auditors should conduct the audit process in a manner which promotes co-operation and good relationship between auditors and other parties involved in the process.  They should represent trust, integrity, confidentiality, competence and fairness. All work performed during the audit process must comply with legislative requirements.

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Auditors have to adhere to standards of behaviour and should be above of any suspicion and blame. They should be objective in dealing with the issues under the review process. The final report and conclusions should be based on evidence obtained in accordance with the relevant standards.  They also need to present competence and apply high professional standards in caring out their work such as honesty, confidentiality, respect and courtesy, due care and diligence.

Audit Documentation Procedure:

In documenting the nature, timing, and extent of audit procedures performed, the auditor must to:

–          Prepare documentation in a manner that helps to carry out an appropriate audit process (collecting a sufficient and appropriate record in accordance with applicable legal and regulatory requirements)

–          Prepare the audit documentation on a timely basis (as per schedule)

–          Document all relevant data and evidence:

Who performed the audit work

Identified characteristics of the specific matters/processes/items tested

Discussions of significant matters with management and others

Meetings minutes

How they addressed any inconsistency in forming the final conclusion

Audit Analytical procedure:

Analytical procedures support auditors during obtaining audit evidence. This includes the way they analyse data and evidence (e.g., investigation, identification of fluctuations or relationships that are inconsistent with other relevant information). Examples of the analytical test include:

–          Trend analysis,

–          Ratio analysis,

–          Reasonableness testing

Audit Sampling procedure:The following policy and procedure set out the factors that must be considered in developing representative samples for audit interviews and worksite sampling.  This also stipulates minimum interview and worksite sampling standards required to meet the audit standards. Auditors must use representative sampling that reflects both the size and complexity of the organization being audited.

Communication procedure:

The quality of communications between directors and audit committees and the auditor is important in supporting audit quality. This communication should include concerns and risks affecting the processes that support the information in the financial report, and how these concerns and risks are being addressed by directors and management and responded to in the audit. 

Reporting procedure:It describes the purpose and the agreed-upon requirements about reporting system (format, timeframe, list of personnel who should receive a copy of the report, evidence required to enable users to understand the nature of the report).

 

Inspection procedure:

This procedure is developed to ensure all work areas are kept free from hazards or potential hazards that may lead to injury or adverse environmental impact. It also outlines who can conduct an inspection (authorised audit companies, internal audit team), schedule of the audit, protective equipment requirements, how often, evidence and confidentiality requirements, and interview process when applicable.

Additional procedures:

In a situation when corrective action and follow-up is required supporting procedures may be implemented. The audit leader needs to develop policy which will define the objectives how the follow-up process will be conducted, how it will be scheduled and prioritised, who will be involved and the frequency of the follow-up activity.

Opening meeting

The lead auditor is responsible for arranging the opening meeting. A team of auditors meets to examine different processes and areas.  The opening meeting conversation should be followed and included in the agenda, such as:

–          Greetings

–          Introduction of the audit team members (identification/credentials, responsibilities)

–          Purpose of the meeting (introduction of the scope of the audit, outline the audit objectives, procedure and standards)

–          Audit Plan (audit schedule and timeframes, a short summary of how the audit activities will be undertaken)

–          Audit policies and procedures

–          Resources (access to information, confidentiality issues,  the auditor’s limited access to certain areas)

–          Introduction to methods and techniques (how data will be collected, analysed and reported)

–          Communication process and techniques during the audit process

–          Logistic process (meeting room locations, necessary equipment and services, working hours)

–          Risk management (safety, emergency and security procedures)

–          Confidentiality (confidentiality and information security)

–          Exit (closing) meeting procedure(final report format

–          Ending meeting – discussion and questions

–          Information about the next meeting – schedule

Other meetings

For more complex or external audits daily meetings such as briefings may be required.  During a typical briefing meeting the audit team should verify processes, identify any uncovered problems, address a solution to the problems and confirm processes to be completed in the required timeframe.

Closing meeting

Once the auditors have completed the audit process, a closing meeting is held with the auditor’s management and other site representatives involved in the audit. It is recommended that prior to the closing meeting, a ‘pre-closing meeting’ should be held to allow the auditors to collate all findings, and analyse the evidence (interviews, document checks, employment site tour). The size and formality of the closing meeting depend on the purpose and scope of the process audit. Managers, senior management, and other relevant personnel involved in the decision-making process should be present at the closing meeting to review findings and achieve consensus on the audit outcome. A final report or its draft can be presented at the closing meeting. The management of the audited organisation and other agreed-upon parties are provided with copies of the report.In the closing meeting, the audit team should provide the final conclusion, provide a briefing on any

areas which require immediate attention, request for any clarification to their evidence if needed and provide a timeframe for completion of the audit report.

Collecting data

Internal auditors use many different techniques to gather information:

–          By being a part of the organisation where the internal auditors have knowledge and understanding of the way the organisation works

–          By observing processes in operation (walking through)

–          By completing a survey to gather specific facts from individuals, a group of people or an organisation

–          By discussion of specific issues in an informal setting (focus groups)

–          By one-to-one interviews with managers, team leaders and employees

There are a variety of techniques to collect and analyse data during the audit process which include: analysis of financial statement, scanning, flowcharting, inspection, electronic data processing, document examination, observation, surveys, sampling techniques, compliance test, interviews and inspections.

Gathered through the audit process data and evidence requires verification. The auditor responsibility is to verify a large amount of information as they can obtain.

The audit ends when the audit plan has been fully completed and the audit report is issued. Audit findings should address any corrective and preventive recommendations which are core to benefiting from the audit process. Audit summary may include:

–          Comments regarding the effective implementation of a process

–          Suggestions for improvement in specific areas (e.g., customers service, product or service quality, work processes,)

–          Categorisation of the non-compliances with reference to their environmental risk

–          Conclusion regarding the conformance of the audited process to the specific requirements and standards (e.g., ISO9001)

In a case when the audit conclusion indicated non-compliances with audit standards a follow-up plan should be defined. The plan needs to specify a course of action to address any non-compliance identified in the audit findings, and to achieve compliance. The action plan can be developed with input from the audit representatives to ensure that the actions required are appropriate and achievable.

Final Report  

Audit reports should include background information, the audit scope, objectives, observations, findings, conclusions, recommendations and agreed management actions. Reports should promote

better practice options and explain why the recommended changes are necessary.A free-form format audit report is commonly used within small and medium size organisations. This report usually includes a summary of the audit findings with the specification of corrective actions and recommendation.The report should be concise, informative, constructive and easy to read. It should indicate:

–          Audit findings

–          Recognition of activities that meet the required standards and outcomes

–          Summary of the evidence that was gathered in relation to each standard

–          Identification and clear description of any areas and problems that need attention

–          Improvement opportunities for consideration

A Corrective Action Report identifies the areas of non-conformity and defines the reasons for the judgement of non-compliance. It also provides recommendations about improvements to be made and timeframes.

Prior the audit process, the report format and timeframes need to be agreed upon, as well as names of those to whom copies of the report should be provided.

The auditing standards require an auditor to comply with relevant ethical requirements, including those about independence, when performing audits, reviews and other assurance engagements. Audit obligations often depend on national, state or territory legislation and regulatory requirements.

Australian Quality Standards refers to manufacturing industries and revolve around products. These Auditing Standards are legislative instruments under the Legislative Instruments Act 2003

Corporations Act 2001- The Corporations Act establishes a comprehensive statutory regime on auditor regulation, including auditor registration requirements, extensive auditor independence requirements and a strong disciplinary framework.

Assurance Engagements / Compliance Engagements / Quality Control – For Firms that Perform Audits and Reviews of Financial Reports and Other Financial Information, Other Assurance Engagements and Related Services Engagements

Compiled Auditing Standard – Compliance with Ethical Requirements when Performing Audits, Reviews and Other Assurance Engagements

Public Finance and Audit Act 1983 – re an effective system of internal control over financial and related operations

The Australian Securities and Investments Commission (ASIC) — is a statutory body established under federal legislation. All the other key bodies performing specified functions in relation to the audit regulatory framework have also been established under the umbrella of the national corporations’ legislation.

 

Personal Skill Audit And Self Assessment

A personal skills audit is a very good way for an individual to identify his/her strengths and needs to develop in a healthy atmosphere. It has been proven very useful for people to keep themselves on the career track mainly ambitious managers and entrepreneurs. The personal skills audit depends on the area of business you are working in too and varies with the different areas and environments.
Here we will realize the whole idea from the prospective of an individual that how one can evaluate himself in the light of some of major personal attributes and skills required for a better and bright career.
The whole personal skills area can be distributed in few sections under which come few questions identifying the presence of that particular skill in your personality through the responses you give against those questions.
I have divided the audit in 5-6 such sections naming Ability and eagerness to learn new things, Information seeing skills, Reading and note making, Communication skills , General business skills, management skills , leadership skills etc. now under these sections are the questions against which an individual’s response is recorded these responses may be in terms of ratings one gives to a particular attribute that is how important a particular skill is or it can be the other way which I have adopted.
Few sections and questions that I have used for my personal skills audit will be presented here to give the exact idea of the whole scenario. The responses are divided in four categories Can do this, need more practice to do this, can’t do this, priority of the skill. (How to change careers a personal skills audit)
Learning and organization-
I plan my strategies to manage my time
I am able to work under deadlines
I am able to prioritize my tasks and continue learning
Communication skills –
I am good with expressing my views verbally
I am confident and have a very little stage fear
I am ready to listen views of others and appreciate it
Management and leadership skills-
I am good with managing my resources and bring the best out of them
I work well as a part or member of the team as well as the leader of the team
I am good with convincing people and get my work done
I am good at addressing and motivating my team mates
Stress management-
I know what the causes of stress are
I know my extent of handling the stress
I can use my strategies to handle any kind of mental stress
These questions will be answered in the responses can do, need practice to do and can’t do along with this they will be given a priority number according to the importance of an individual skill in one’s personality.
Personal Development Plan
Next part is analyzing the Personal development planning which will directly be linked with the personal traits we have discussed above as on the basis of our responses given against each of the question under each section we can figure out our strong and weak points and know what we are really good at and what not which will help us to bring our best qualities out and strengthen them also there might be some attributes of our personality which may be hidden and might come out after this analysis and can be used later on for some good. (How to change careers a personal skills audit)
Under personal development planning our first question is-
Am I able to identify my personal goals?
As we know without a goal a person is nothing but a rolling stone which goes in any direction he is kicked but that only because he cannot think about this we human beings have this ability to set and figure out personal goals for ourselves and make efforts to achieve them. Every individual might have a different goal some of us want to be big business men and some want to be social workers for me it is a combination of both I want to be an entrepreneur who can bring technology to masses and give them its advantage.
Am I being able to judge my strengths and area of development?
The idea behind the personal skills assessment was bringing out strong and weak points of an individual’s personality and finds the scope of improvement in the weak points if any. So it’s very important to know your strengths and use them in a constructive manner.
Am I being able to spot opportunities of learning and growth of my career?
This is one very important point for every ambitious individual who is looking to grow the field of his expertise. Spotting out opportunities which can give you chance to enhance your learning and scope to grow your career is of utmost importance in any working environment and should always be kept in mind.
Now these questions are needed to be asked in a regular interval of time from ourselves and take the feedback of how much we are following the plan we had set for ourselves. This feedback will always help us to asses us in the light of the goals set before us and give us the exact idea of any further improvements if needed.

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Overall Progress & Setting Objectives
The objective one puts in front of himself is the ultimate goal he is looking for but things like this do not come very easily and soon. There is a lot of effort and regular monitoring is involved. I review my objectives and steps I suggested to be taken to achieve the same in every month and analyze the extent I am close to it and what were the right steps I took in this direction and what were wrong. for example if I have decided to read a particular book at the starting of a month and I have spend most of the time in other activities rather than reading that book then at the end of the month when I will review the whole situation it will come out itself that my focus and will power is not that strong and I need to work on that which will help me to achieve my objective ultimately which is reading the book in this case and as this is just an example the concept can be understood in a broader prospective which is career and life. (Business tips and tricks)
Learning Style
Each individual has its own way of learning and analyzing the information in different way. While most of the people deliver the information is one convenient way still here we will analyze different important and famous learning styles which are used today.
There are many ways to classify the learning styles and most of such classifications are based on individual’s perception. On the basis of the perception of one such individual we have categorized the learning styles in four categories listed below-
Converging- It is based on understanding the abstract concepts and implementing them practically
Diverging – It is based on coming up with new ideas and seeing things from a different prospect
Assimilating- It is based on building theoretical models by inductive reasoning
Accommodating- It is based on actively participating in the important ideas going around
My learning style among these four categories is Converging as I believe in understanding the concept first and then visualize it in a real time scenario with the help of technical and personal skills I am having. (Business tips and tricks)
Lifelong Learning
The concept of lifelong learning is not new usually people expect learning to be a source and medium too to build a bright career and earn a pile of money which is not at all wrong but that should not be the ultimate objective as we say it’s not all about luxury but for the life as well.
Four very important factors this whole idea strongly lies on are
Learning to know
Learning to do
Learning to live together
Learning to be
It also proves the point that learning is an integral part of life not only to earn money but also to live a happy and transient life.
My suggestion to encourage the lifelong learning is the same frame of mind which promotes education and learning beyond the money and luxury column and it should always kept in mind that learning doesn’t have any age or status bar and it is supposed to move with you throughout your life being a very integral part of your life.
Time Management Strategies
The major time management strategies I have adopted to achieve my objectives are following with their importance in one’s daily schedule.
Don’t waste time: Seems quite obvious but very important point. I used to waste a lot of time watching videos, checking email often and using social networking websites which consumed most of my time without giving me any valuable knowledge so I decided to quit that.
Make a Calendar: Running things that you have to do in your head is not an ideal way to keep track of things it will be better to have a calendar and mark important date in it because if you are free it might be easy to keep such things in mind but once you have a lot of work it is hell of a job and in a fast era like today you are not allowed to make many mistakes so keep yourself updated.
Work from anywhere and everywhere: Use online tools like Gmail, Google documents and others so that you can work from anywhere from your computer as internet is available everywhere today it will help you to stay ahead of the curve.
Break your work into chunks: Do work in small pieces as it might be possible that you have a little time but a lot of work so you might not start as you can’t finish it in that much of time so break your work in small pieces. (6 essential time management strategies)
 

Impact of Audit Quality of Real Earnings Management

Abstract
This study aims to evaluate the influence of audit quality (auditor size and auditor tenure), political connection, and institutional ownership toward real earnings management. Purposive sampling was conducted and 83 manufacturing companies registered in Indonesian Stock Exchange during 2010-2014 were acquired as the samples. For testing the hypotheses, panel data regression random effect model was used. The results showed that auditor size and institutional ownership had positive influence toward real earnings management, while audit tenure and political connections did not influence real earnings management. The control variable testing showed that  leverage and loss had negative influence toward real earnings management, while cash ratio had positive effect towards real earnings management. These result have implication for the investors to pay attention to operating cash flow average, because there is still a possibility of real earnings management, although the company auditors were from the big-4 auditors.
Keywords: real earnings management, audit quality, auditor size, audit tenure, political connections, institutional ownership..
INTRODUCTION
Managers can apply accrual earnings management and real earnings management to achieve the desired profit (Fisher and Rosenzwig, 1995; Roychowdhury, 2006). The real earnings management is impose bigger long-term costs, because it has negative consequences toward future cash flow which reduce firm value (Roychowdhury, 2006; Cohen et al., 2008; Cohen and Zarowin, 2010). Graham et al., (2005) and Cohen et al., (2007) clarify that the reasons why a company using real earnings management is to avoid auditors’ and regulators’ detection. The real earnings management is more difficult to detect because it is almost similar to a company’s operational activity (Kim et al, 2010).

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Becker et al. (1998); Johnson et al.( 2002); Balsam et al.,(2003); Chen et al. (2011), and Inaam et al. (2012)  showed that audit quality (auditor size and auditor tenure) reduce accrual earnings management. Therefore, companies that want to conduct earnings management will shift from accrual earnings management to real earnings management (Chi et al., 2011). Auditor size positively affect real earnings management (Chi et al., 2011; Inaam et al., 2012). Meanwhile, Nihlati and Meiranto (2014) showed that the auditors size negatively impact real earnings management. Chi et al. (2010) found that auditor tenure had positive influence toward real earnings management. While Inaam et al.(2012), Herusetya and Pujilestari (2013) found that auditor tenure did not affect real earnings management.
Inaam et al., (2012) conducted a research about the influence of audit quality toward the real earnings management in Tunisia and suggested that the future research can include political connection and institutional ownership as independent variables. Pollitically connected companies have bad reporting quality (Chaney et al., 2010). Meanwhile, Batta et al. (2014) found that political connection positively affect the reporting quality. The phenomena of pollitically connected companies in Indonesia is state-owned enterprises became disorganized after were interfered by political parties (Muqoddas, 2012). Indonesian Corruption Watch data showed that there were 48 legislators who were entrepreneurs that were exposed for corruption case (Gabrillin, 2014).
Shleifer & Vishny (1986); Bathala et al. (1994); Velury & Jenkins (2006); Mehrani et al. (2016) showed that institutional ownership reduce accrual earnings management. The institutional investors monitoring toward managerial process and accounting information accuracy are stronger. For avoiding detection by the institutional investors, companies will shift from accrual earnings management to real earnings management.
The aim of this research is to evaluate the influence of audit quality, political connection and institutional ownership toward real earnings management. This study contributes in adding political connection and institutional ownerships as independent variables, as suggested by Inaam et al. (2012). Up to now, studies about real earnings management in Indonesia are rarely conducted and, if any, they have not correlated political connection and institutional ownerships toward the real earnings management study yet, so this study will fill in that gap.
As the structure of this paper, literature review and hypotheses development will be discussed on the next part. The research method will be discussed in the third section. This is followed by result and discussion and the final section concludes the study.
LITERATURE REVIEW AND HYPOTHESES DEVELOPMENT
Auditor Size and Real Earnings Management
Earnings management can be applied through accrual and real activities (Roychowdhury, 2006; Zang, 2007; Cohen and Zarowin, 2010). The methods of real earnings managements are sale manipulation, overproduction, and reducing discretionary expenses (Roychowdhury, 2006). DeAngelo (1981), Becker et al. (1998) and Krisnan (2003) found that big size auditors  have better audit quality  than small auditors.  The Big-4 auditors is considered to be more competent than the non Big-4 auditors if seen from their education, training, and experience (Amijaya and Prastiwi, 2013), their independencies (Zou and Elder, 2003) and their good reputation (Christiani and Nugrahanti, 2014). Big-4 auditors’ competency will ease the earnings management detection. Therefore, companies tend to choose real earnings management, so it will be more difficult to be identified. Cohen and Zarowin (2010), Chi et al. (2011), Inaam et al. (2012) found out that auditor size positively influences real earnings management.
H1: Auditor size has positive influence toward real earnings management.
Auditor tenure and Real Earnings Management
Auditor tenure is the number of years of an auditor being assigned by a company (Myers et al., 2003). The longer engagement duration, the higher auditor’s knowledge about that company, so it ease in detecting earnings management (Giri, 2010). The company will shift from accrual earnings management to real earnings management so that it will not be detected easily. The real earnings management tends to be out of the auditors’ supervision (Chi et al., 2011) and it will be hard to detect because it is almost the same as company’s daily operational activity (Kim et al., 2010). Cohen and Zarowin (2010) and Chi et al. (2011) found that auditor tenure has positive influence toward real earnings management.
H2: Auditor tenure has positive influence toward real earnings management.
Political Connection and Real Earnings Management
A company can be called politically connected if the biggest shareholder (has minimum 10% of voting rights) or top officers serves as the parliamenterian, minister, or has close relation with a politician or political party (Faccio, 2006). A company which has political connection will get the benefit such as capital allocation (Fisman, 2001; Goldman et al.,2010), better business opportunities (Fisman, 2001), and bailouts from the government (Faccio et al., 2006).
If a company is not able to maintain its reputation and profit, It will loose special previlege from political connection (Braam et al., 2015). For increasing their performance, the companies tend to perform real earnings management. Earnings management detection would lead decreasing in company’s reputation, increasing in political cost and the company’s external interventions (Watss and Zimerman, 1990; Faccio, 2006; Ramanna and Roychowdhury, 2010; Kothari, 2012). For avoiding that detection, the company will shift the accrual earnings management to real earnings management. Chaney et al.,  (2011) found out that politically connected companies tend to conduct earnings management.
H3: Political connection has positive influence toward real earnings management.
Institutional Ownership and Real Earnings Management
Institutional investors generally have a big number of shares, so they carry out strict monitoring to the companies’ performance and  companies’ information quality (Velury and Jenkins, 2006; Pound, 1988; Shleifer and Vishny, 1986). Bushee (1998) and Potter (1992) found out that institutional investors were too focus on the short-term performance, so they force the managers to achieve that short-term profit. For improving their performance and for avoiding the detection from institutional investors , the managers will prefer real earnings management than accrual earnings management.
H4: Institutional ownership has positive influence toward real earnings management.
RESEARCH METHODOLOGY
Samples and Source of Data
This study used the manufacturing companies listed in Indonesia Stock Exchange during 2010-2014 periods. The criteria for purposive sampling method are the companies published annual report sequentially during that periods and the annual reports were finished on the December 31st. There were 83 companies were selected as the samples, so there were 415 firm year observations.
The annual reports acquired from the Indonesia Stock Exchange website. The political connection data were acquired from (1) annual report and tracing down the Board of Directors and Board of Commissioners’ biography from the sites in Google, (2) the Indonesian Republic National Portalwebsite (indonesia.go.id), the Indonesian Republic House of Representative website (www.dpr.go.id), and Tokoh Indonesia – Indonesian Leaders (www.tokohindonesia.com).
Variables
Real Earnings Management (Dependent Variable)
Abnormal Cash flow from operation will be used as proxy of real earnings management. When the companies apply real earnings management, the average of  CFO will be negative (Roychowdhury, 2006; Chi et al., 2011., Inaam et al., 2012 and Ratmono, 2010).

CFOt= operating cash flow of company i in year t
At-1= the total asset of company i in t-1 year
St= the total sales of company i during year t
εt= abnormal cash flow from operation (regression residual, real earnings management proxies, REM)
Independent Variables
Political connection, auditor size, auditor tenure and institutional ownership are the independent variables.
Table 1: Independent Variables’ Measurement

Independent Variables

Measurement

Political Connection (

Political connection variable will be measured by calculating the number of Board of Directors and Board of Commissioners, both the chiefs and the members who are also the House of Representative members, ministers or vice ministers, or related to prominent politicians and political party members (Braam et al., 2015)

Auditor size (AUDSIZE)

A Dummy variable, 1 if the firm was audited by a Big 4 auditor, 0 otherwise (Chi et al., 2011; Inaam et al., 2012.,Christiani and Nugrahanti, 2014).

Auditor Tenure (TENURE)

The number of engagement years or auditing period assigned in which the auditors from the same Public Accountant Firm conduct audit engagement to the auditee during 2010-2014 periods (Chi et al., 2011; Inaam et al., 2012)

Institutional Ownership
(INSTOWN)

The percentage of shares owned by the institutional investors (Velury & Jenkins, 2006; Mehrani et al., 2016; Wiranata and Nugrahanti.,2013)

Control Variables
Leverage, company’ loss and cash ratio were used as control variables in this study. Leverage/ LEV (the total debt/ the total asset) positively influence the REM (Herusetya and Pujiletari, 2013). The loss of the company is measured using a dummy variable, 1 if company has net loss and 0 otherwise (Herusetya and Pujilestari, 2013). One of the reasons why a company applies real earnings management is to cover up the company loss (Roychowdhury, 2006). Cash ratio (CCE) is the ratio of the cash and cash equivalents toward the total asset (Herusetya and Pujilestari, 2013). The higher CCE ratio, the faster company’s cash flow, so it will ease the manager in utilizing the available cash to have earnings management (Herusetya and Pujilestari, 2013).
Regression Model
Panel data regression analysis was chosen to perform the hypotheses testing because this study used data combination of time series and data cross section (Winarno, 2015). Hypotheses H1, H2, H3, H4 and control variable in this study will be tested using empirical model as follows:

RESULT AND DISCUSSION
Descriptive Statistics
Table 2 below showed descriptive statistics used in this study.
Table 2 Descriptive Statistics (Pooled Sample, n= 415)

Variable

Mean

Maximum

Minimum

Std .Deviation

REM

-0.006352

0.659900

-1.217470

0.188328

POLCN

0.245783

2

0

0.468655

AUDSIZE (dummy variable)

1

0

0.485552

TENURE

2.554217

5

1

1.381844

INSTOWN(%)

70.4841

100

0

19.61332

LEV

0.470906

4.189190

0.000265

0.321157

LOSS (dummy variable)

1

0

0.339475

CASH

0.102345

0.500295

0.000078

0.122287

From 415 firm years, 157 companies (37.8%) used the big-4 auditors and 258 companies (62.2%) used the Non-Big 4 auditors. Besides, there were 55 companies (13.3%) reported a loss.
Real Earnings Management (REM) Testing
Wilcoxon Signed Ranks Test was conducted to confirm whether REM are validly applied in the sample companies.  The result of this test are presented in appendix 1. If the average abnormal CFO was negative, the companies were assumed to apply REM in operating cash flow (Oktorina & Hutagaol,2008). The Wilcoxon Signed Ranks Testing result showed that the mean of abnormal CFO was -0.006352 and its significance value was 0.046, so it was confirmed that those companies applied REM through operating cash flow.
Panel data Model Testing
Chow Test and Hausman Test for determining the appropriate estimation method were presented in appendix 2. Based on the Chow Test and Hausman Test results, the estimation method applied in this study was panel data regression using random effect model.
Hypotheses Testing
The results of hypotheses testing using panel data regression random effect model within 5% alpha level were presented in Table 3.
Table 3 Hypotheses Testing Results

Variable

Expected sign

Coefficient

Probability

Conclusion

Intercept

-0.077146

0.0997

AUDSIZE

+

0.084373

0.0031***

H1 accepted

TENURE

+

-0.008594

0.0968

H2 rejected

POLCN

+

0.001902

0.9380

H3 rejected

INSTOWN

+

0.001100

0.0372**

H4 accepted

LEV

+

-0.075769

0.0071***

LOSS

+

-0.067431

0.0083***

CASH

+

0.268174

0.0043***

Dependent variable     Real earnings management (REM)
R-squared                  0.119266
Adjusted R-squared 0.104118
F-statistic                  7.873503
Prob(F-statistic)         0.000000
**significant on alpha 5%
***significant on alpha 1%

Auditor Size and Real Earnings Management
The H1 testing shows that auditor size positively influence REM. This result is in line with Chi et al. (2010), Cohen and Zarowin (2010), Inaam et al. (2012), Nihlati and Meiranto (2014). The big-4 auditors are assumed to have better skills compared to non big-4 auditors, regarding from their educational backgrounds, trainings, and experiences (Amijaya and Prastiwi, 2013), their independencies (Zou and Elder, 2003) and their good reputation (Christiani and Nugrahanti, 2014).  The big-4’skills will ease the auditors in detecting the accrual earnings management. Hence, companies will cover up the earnings management from the  auditors and prefer to apply real earnings management. Real earnings management is harder to be identified than accrual earnings management since it is almost the same as the companies’ daily operational activity (Kim et al., 2010, Graham et al., 2005; Gunny, 2010; Badertscher, 2011).
Auditor tenure and Real Earnings Management
The H2 testing result shows that auditor tenure did not had an effect toward REM. This result consistent with Inaam et al.(2012), Herusetya and Pujilestari (2013), Nihlati and Meiranto (2014). Gul et al. (2009) categorized the audit placement period into three categories, the short term (2-3 years), medium term (4-8 years), and long term (9 years).  Table 2 show that auditor tenure average is 2.5 years, and the short auditor tenure had not been able to influence real earnings management.

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By limiting auditor tenure, there will be a gap between the auditor and the company. In order to verify a company, auditors had to identify in advance the companies’ characteristics and managements, and it usually took quite a long time (Kono and Yuyetta, 2013). Amijaya and Prastiwi (2013) stated that why audit tenure did not have any influence toward earnings management was the auditors’ incapability in identifying earnings management.
Political Connection and Real Earnings Management
Based on Table 3, it can be seen that political connection did not had an effect toward REM. This result is in contrast with Braam et al. (2015). Political connection did not had an effect toward real earnings management because the numbers of political connections in the samples was few, which was 27.71% (23 out of 83 companies). There were only one person in board of directors and board of commissioners that were involved in political connection, so political connections did not influence real earnings management.
Institutional Ownerships and Real Earnings Management
The H4 testing result indicates that institutional ownerships positively influence REM. The institutional ownerships’ mean was 70.48%. Institutional investors who had a big number of shares will strictly monitor company’s performance and company’s information quality (Velury and Jenkins, 2006; Pound, 1988; Shleifer and Vishny, 1986). The strict monitoring made the companies that want to apply earnings management shift from accrual earnings management to real earnings management. Institutional investors were too focus on short term performance, so they urged the managers to fulfill that short term profit (Bushee,1998; Potter, 1992). For increasing their performance and for avoiding institutional investors’ detection, the managers would prefer real earnings management to accrual earnings management.
Leverage, Company Loss, Cash Ratio and Real Earnings Management
The testing results of control variables show that leverage negatively influenced REM. If a company has high levels of debts, it has to pay principal and high debt interest. The obligatory of those payments limit managers in using cash flow, including for real earnings management (Zamri et al.,2013).The company loss negatively influences REM. This finding is in line with Herusetya and Pujilestari (2013) and Roychowdhury (2006). When the company reported positive earnings, the company was assumed that they were covering up the loss through REM. If the company reported negative earnings, the company would be assumed that they did not apply REM, and the company was considered to not cover up the loss (Herusetya and Pujilestari, 2013). Cash ratio positively influence REM. The higher cash ratio, the better company’s liquidity, so it would ease the managers in utilizing the provided cash for real earnings management (Herusetya and Pujilestari, 2013).
CONCLUSION
Although a study about audit quality and real earnings management has been conducted before, this study contributes in adding new independent variables, which are political connection and institutional ownerships. The testing results show that the auditor size and institutional ownerships can increase real earnings management. Meanwhile, audit tenure and political connection do not influence real earnings management. The testing toward control variables showed that leverage and company loss negatively influence real earnings management, while cash ratio had positive influence. The applied implication of these result is the investors need to see the operating cash flow average , because there is still a possibility of real earnings management, although the company auditors were from the big-4 auditors.
The limitation of this study was a few number data of political connection although depth investigation had been carried out by looking at the name of legislative members/ ministers and vice ministers/ kinships to members of political parties. For the future study, the political connection criteria can be added by including the Indonesia National Forces retirees or ministry officials (for example the secretary general, directorate general, staff member of ministry, assistance of ministry). The future study may also add corporate governance mechanism as independent variables, such as managerial ownerships, auditing committee, and independent board of commissioners.
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