More measures: (performance measurement & cost reduction).

As regulators increase emphasis on a top-down approach to auditing, auditors are being asked to provide additional performance measurement services that focus on obtaining information on the business as a whole as a basis for evaluating management representations.

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While it may seem difficult to incorporate these changes into the conventional audit without significantly increasing the scope and cost, there is practical guidance on reviewing strategic management in an organization, evaluating performance measurement techniques and examining for potential cost reductions that can ease that difficulty.

REVIEWING STRATEGIC MANAGEMENT

Generally, best business practices related to strategic management include executives developing a mission statement based on vision; establishing objectives; looking for environmental threats and opportunities; reviewing organizational strengths and weaknesses; selecting and implementing strategies; and evaluating results.

When auditors review a company's strategic management their examination includes such probes as:

* Is there a mission statement that describes the company's product and functions?

* Do the objectives reflect the company's mission? Are they specific and measurable? Does each objective contribute to overall goals?

* Has the company identified potential opportunities and threats, including socio-economic, technological, regulatory and competitive?

* Do executives recognize the organization's strengths and weaknesses, including in the areas of production and operations; resources; engineering and research; accounting and finance; marketing; and information technology?

Auditors are especially interested in the effect of environmental threats, such as economic changes and organizational weaknesses.

For example, if management devotes little effort to marketing while the company's competitors have aggressive marketing campaigns, the company will likely experience a drop in sales.

If the client has an effective strategic management program, the auditor can review the results of the external and internal analyses and determine the effect on the financial statements and performance. If there is no program, the auditor can collaborate with management to perform the analyses.

The strategic management program may be formal, in written form, or the auditor may obtain information by discussion with management. The development of a strategic management program is the responsibility of management and the audit opinion does not extend to the program. The auditor reviews strategic management as part of the basis for performance measurement. If the auditor finds during the interim audit that management does not do any strategic analysis, he can recommend that it be done as part of his recommendations for improving performance.

BALANCED SCORECARD

To gauge their success and future performance, many Fortune 500 companies use leading indicators that stress management of the activities that drive revenue and costs, rather than only analyzing the financial statements after the activities have occurred. The focus is on current operations rather than historical records.

The balanced scorecard is one common approach, which covers financial strength, customer satisfaction, business processes, innovation and learning.

For example, CIGNA uses the balanced scorecard approach to determine half of its annual employee bonus amounts. Under this method, goals in each area are assigned one or more measures considered necessary for achieving a desired strategic success. Some of the key measures include customer satisfaction (market share, customer complaints, percentage of repeat orders and number of returns); processes (production output, timeliness of shipments and number of defects); learning and innovation (number of new products introduced, number of training courses and turnover); and financial (conventional ratios, such as return on equity and return on investment).

These measures are interrelated, since learning and innovation can result in process improvement, which leads to increased customer satisfaction that then can result in improved financial profits.

If the client has incorporated the balanced scorecard approach, the auditor can review the ratios and other information to flag areas that warrant additional attention by management, such as percentage of number of returns by customers.

If this approach is not used, the auditor during the interim audit can encourage the company to develop the data, which can then be reviewed. It is up to management to determine the critical ratios to be tracked as part of performance measurement.

OPERATIONAL CONTROL TECHNIQUES

To understand the business and evaluate performance, the auditor also can become familiar with the techniques management uses to direct and control operations, such as policies and procedure manuals, organization charts, standards of performance, reports, supervisory and internal audit reviews, and budgets.

For example, auditors study internal audit reports and results to determine areas for audit emphasis as well as potential cost savings. In reviewing reports they determine whether there are too many or duplicate reports, to whom they are routed, if corrective action is taken on recommendations, and if the company is preparing necessary reports.

Similarly, budgets can be compared with actual costs and analysis made of the effect of variances.

COST REDUCTION

Auditors continually look for areas of possible cost reduction. A useful model for this is based on a review of actions, or decisions, made in such functional areas as production and operations, including purchasing; personnel; engineering and research; accounting and finance; marketing; and information technology. The following shows the sequence of recording events in an organization.

ACTIONS (Decisions) > Data > Classification > Reports

In the conventional financial audit, the auditor goes back from financial statements to support documentation, while in this model, the auditor reviews support for actions taken in the functional areas to determine potential cost savings.

An example of the approach used in reviewing step-by-step actions in purchasing with respect to potential cost savings is shown in Figure 1 above.

Auditors can use this model independently or incorporate it in their review of documentation in support of transactions, such as check disbursements. Being aware of specific risks in a company's functions allows auditors to extend their tests as needed to determine cost savings. The model can be applied across the board or performed on a cyclical basis, just as some audit procedures are scheduled in a financial audit.

RISK ANALYSIS AND COST SAVINGS

When looking for cost savings, auditors attempt to determine the risks from alternative actions, the probability of losses from those actions, and alternative actions to reduce or eliminate risks.

Using the sequence of actions described on this page, the following is an example of risk analysis applied to the sales and distribution function. In addition to potential problems in proper cut-off, the following risks should be assessed:

* Shipping orders without proper credit authorization;

* Shipping orders without proper discount or freight terms;

* Shipping incorrect goods;

* Shipping duplicate orders;

* Shipping damaged or soiled goods; and

* Accepting returns without authorization.

Auditors perform general risk analysis as the basis for planning an audit. Areas for potential cost savings in operations, as well as areas affecting the financial statements, can be included as potential risks.

COORDINATION WITH THE CLIENT

Success in implementing performance measurement rests on client acceptance. The client should promote and encourage the use of performance measurement in daily management, and assure that individuals are held accountable for results.

Management must identify measures that are strategically important and assure that performance is tracked, since the auditors will review the measures as the basis for audit conclusions.

If the client has not used a system such as balanced scorecard, the auditor can monitor the development of measures best suited for the company and examine the actions taken by management when the results of key indicators are less than expected.

(FIGURE 1)

Cost-saving Measures

Company Action             Auditor Identified
                           Potential Cost Savings

Determine need             Item not justified or already in
                           stock

Designate specifications   More expensive or complex item ordered
                           than needed

Lease vs. buy alternative  Selection of wrong alternative

Select vendor              Sole-source procurement, insufficient
                           competitive bids

Purchasing arrangements    Emergency purchases, premium
                           transportation non-economic
                           quantities

Receiving                  Follow-up on warranties for defects

BY HERBERT WITT, CPA

Herbert Witt, MBA, CPA, CIA, CGFM has authored several books and articles and teaches a strategic management course at University of San Francisco. You can reach him at [e-mail].