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Discovering opportunities for a new working relationship between internal & external auditors.

T Auditing Standards Board of The American Institute of Certified Public Accountants recently issued a Statement on Auditing Standards (SAS) 65, "The Auditor's Consideration of the Internal Audit Function in an Audit of Financial Statements."(1) This statement supersedes SAS 9, "The Effect of an Internal Audit Function on the Scope of the Independent Auditor's Examination"(2) and significantly affects the working relationship between external auditors and internal auditors.

Internal auditors have long recognized that providing copies of internal audit reports and working papers may help reduce the external auditors' work (and fees). Often independent audit procedures duplicate work already done, or work which may be done more efficiently, by internal auditors. Under SAS 9, opportunities to aid the external auditors were somewhat limited. With the issuance of SAS 65, the internal audit function can effect new efficiencies in the financial statement audit which accrue to the benefit of the company.

The major provisions of the proposed standard are highlighted here and discussed in detail in later sections. The new standard:

* Allows the external auditors to place increased reliance on work performed by internal auditors.

* Outlines three major areas in which the external auditors may use work done by internal auditors in certifying financial statements.

* Provides guidance in coordinating the work of the internal and external auditors.

* Suggests methods of evaluating the competence and objectivity of the internal auditors.

* Outlines ways that the external auditor may evaluate the effectiveness of the work done by the internal auditors.

* Discusses how internal auditors may provide direct assistance to the external auditor.

Reliance on the Internal Auditors' Work

SAS 65 allows the external auditors to rely heavily on the work of the internal auditors. However, the SAS does not require reliance on the internal auditor's work. The document reminds the external auditor that the internal audit function is part of the control structure and, therefore, must be included in the external auditor's understanding of the control structure.(3)

Should external auditors opt to rely on the work of the internal auditors, there are three potential areas of reliance:

* Understanding the control structure;

* Assessing control risk;

* Performing substantive tests.

The internal auditors' work can aid the external auditor in understanding the design of the control structure. For example, internal auditors may be able to provide system and document flowcharts of the accounting system. They may also be able to help the external auditors determine if the prescribed system has actually been placed in operation.

Internal auditors can also furnish documentation of tests they have conducted of the effectiveness of components of the control structure design. Such internal audit work can have a major impact on the external auditors' assessment of control risk and, as a consequence, on the extent of audit procedures and cost to the company. The proposed SAS allows the external auditors to consider the results of tests of controls performed by the internal auditors and to then "...change the nature, timing, and extent of testing the (external) auditor would otherwise need to perform".

The work of the internal auditors can also play an important role when external auditors are performing substantive work. By placing reliance on the internal auditors' work, the external auditors may be able to alter their substantive procedures in some areas. For example, by relying on the internal auditor's observation of inventory at various locations, the external auditors may be able to reduce the number of sites they visit.

Extent of Reliance

How much reliance can the external auditors place on the internal auditors' work? Although the external auditors may rely on the work of their internal colleagues, the external auditors must bear in mind that the internal auditors' work constitutes indirect evidence for the financial statement audit and the final responsibility lies with the independent auditor. Professional standards for independent audits indicate direct evidence is more persuasive than indirect evidence; only the external auditor can determine the importance of indirect evidence in rendering an audit opinion.(4) As the materiality of an account or class of transactions becomes more stringent, the need for more evidence obtained directly by the external auditors increases.

The assessed levels of inherent risk and control risk bear on the independent auditor's reliance on the work of the internal auditor in a manner similar to materiality. The higher the assessed levels of inherent risk and control risk, the greater the need for the external auditor to obtain direct evidence regarding the account or class of transactions.

Finally, the external auditors should consider the subjectivity of the assertion. For example, the valuation assertion for inventory is more subjective than the rights and obligations (ownership) assertion. The more subjective the assertion, the more direct evidence the external auditor must obtain. For less subjective assertions, the external auditors can rely to a greater extent on the work of internal auditors.

Coordination of Work of Internal and External Auditors

While effective communication and coordination of work between internal and external auditors is always important, it takes on new urgency with the release of SAS 65. In order to take full advantage of the efficiencies made available through increased reliance on the work of internal auditors, communication practices should be enhanced. A partial list would include:

* Periodic scheduled joint meetings of the two groups for a free exchange of ideas;

* Work schedules exchanged and all parties encouraged to discuss perceived accounting and auditing problems;

* Each group of auditors keeping the other informed as to its findings as work progresses;

* Each audit group provided access to work papers by the other group;

* Each group of auditors reviewing the other's reports at the completion of the engagement.

Evaluating the Competence and Objectivity of the Internal Auditor

If reliance is to be placed on the work of internal auditors, both the competence and the objectivity of the internal auditors must be assessed. Information concerning these qualities can be obtained from several sources: prior experience with the client, inquiries of the client's management and a review of the results of a recent quality assurance review (QAR) of the internal audit function.

Competence

Competence of internal auditors has to do with their technical ability to do quality work and is a measure of the quality of the staff--individually and in the aggregate.

Evaluation of competence is based on the professional experience and education of individual staff members and factors relating to the department. SAS 65 implicitly recognizes the increasing professional status of internal auditing by explicitly listing professional certification and continuing education as factors to be considered when evaluating competence. The CMA certificate and the continuing professional education requirements of the Institute of Management Accountants are positive factors in establishing competence. Other factors include:

* Educational level;

* Practices regarding assignment of internal audit staff to audit projects;

* Audit policies and procedures;

* Audit programs;

* The quality of internal audit working paper documentation;

* Evaluation of internal audit staff performance (in prior years);

* Supervision and review of internal audit activities; and

* Policies regarding the assignment of internal auditors to engagements.

Objectivity

Objectivity is the quality of being unbiased or neutral and relates to the ability of the internal audit staff to resist organizational pressures to alter professional judgments. When assessing the objectivity of the internal auditors, the external auditors will consider factors relating to the organizational status of the internal audit function and the objectivity of the individual personnel.

The internal audit department should be placed at a high level in the organizational structure. The external auditor may consider whether the internal auditors report to a person or function high enough to assure there is broad audit coverage of the entity. They will also determine whether internal audit reports are addressed to management or directors who are at levels sufficient to take recommended actions, if warranted. External auditors will consider whether the internal audit function enjoys direct access to the audit committee and reports to it regularly and whether the audit committee is actively involved in decisions relating to employment of the internal auditors (hiring, firing, promotion, salaries).

To evaluate the objectivity of individual audit staff members, external auditors will want to know if internal auditors are prohibited from examining areas where relatives work in important or sensitive positions and are barred from auditing areas in which they have recently done non-auditing work or are scheduled to do so in the near future.

Evaluating the Effectiveness of Internal Auditor's Work

Regardless of the level of competence and objectivity of the internal auditors, the external auditors are required to evaluate the quality and effectiveness of the work done by internal auditors.

* The scope of the work performed by internal auditors should be appropriate to the objectives of the financial statement audit.

* Audit programs used by internal auditors should be sound.

* There should be evidence the work was properly supervised and reviewed.

* Workpaper documentation should be adequate.

* Conclusions reached should be appropriate to the circumstances.

* Internal audit reports should be consistent with the results of the work as documented in the workpapers.

For the external auditors to evaluate the factors listed, they must test the work performed by the internal auditors. This may be accomplished either by testing some of the work performed by the internal auditors or by independently testing items similar to those previously examined by internal auditors.

Direct Assistance

SAS 65 allows the internal auditors to directly assist independent auditors in the three areas mentioned earlier: understanding the control structure; performing tests of controls; and performing substantive tests.(5) The external auditor is, of course, responsible for supervision of the internal auditors, review and evaluation of their work, and testing of their work. Good communication is of primary importance in this area of work. Internal auditors should be informed of:

* their responsibilities;

* the objectives of the procedures; and

* matters that bear on the nature, timing and extent of audit procedures.

Internal auditors should also be asked to disclose significant accounting and auditing matters that have come to their attention.

Conclusion

SAS 65 provides opportunities for increased efficiency and lowered cost of financial statement audits. By placing more reliance on the work of internal auditors, the external auditors can reduce the total volume of their own work. They may rely either on work performed independently by the internal auditors or on internal auditors' work supervised by the external auditor. Internal auditors can help the external auditor understand the control structure, assess control risk and perform substantive tests. When relying on the internal auditors' work, the external auditors generally test some of the work. The extent of this testing depends on the competence and objectivity of the internal auditors.

Regardless of the extent to which the external auditors rely on the internal auditors' work, the external auditors must bear in mind that they are solely responsible for the opinion on the financial statements. That responsibility cannot be delegated or shared. Although the internal auditors may aid the external auditors greatly, the external auditors must still gather some minimum amount of sufficient, competent evidence in order to support the audit opinion.

Footnotes

1 April, 1991.

2 1975.

3 This was originally noted in SAS 55, "Consideration of the Internal Control Structure in a Financial Statement Audit," (AICPA, 1988) and is reiterated in SAS 65.

4 SAS 31, "Evidential Matter," AICPA, 1980, para. 19.

5 Using professional internal auditors, who may have more expertise than the external auditor who is acting as supervisor, as assistants may cause feelings of resentment (on the part of the internal auditors) and inadequacy (on the part of the external auditors). Such personnel problems are not addressed in SAS 65, but are discussed in articles and texts in the professional internal auditing literature.
COPYRIGHT 1993 National Society of Public Accountants
No portion of this article can be reproduced without the express written permission from the copyright holder.
Copyright 1993 Gale, Cengage Learning. All rights reserved.

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Author:Colbert, Janet L.
Publication:The National Public Accountant
Date:Jan 1, 1993
Words:1938
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