Internal audit


Internal audit
Accountancy
Key concepts
Accountant · Accounting period · Bookkeeping · Cash and accrual basis · Cash flow management · Chart of accounts · Journal  · Special journals · Constant Item Purchasing Power Accounting · Cost of goods sold · Credit terms · Debits and credits · Double-entry system · Mark-to-market accounting · FIFO & LIFO · GAAP / IFRS · General ledger · Goodwill · Historical cost · Matching principle · Revenue recognition · Trial balance
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Cost · Financial · Forensic · Fund · Management · Tax
Financial statements
Statement of financial position · Statement of cash flows · Statement of changes in equity · Statement of comprehensive income · Notes · MD&A · XBRL
Auditing
Auditor's report · Financial audit · GAAS / ISA · Internal audit · Sarbanes–Oxley Act
Accounting qualifications
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Internal auditing is 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.[1] Internal auditing is a catalyst for improving an organization’s effectiveness and efficiency by providing insight and recommendations based on analyses and assessments of data and business processes. With commitment to integrity and accountability, internal auditing provides value to governing bodies and senior management as an objective source of independent advice. Professionals called internal auditors are employed by organizations to perform the internal auditing activity.

The scope of internal auditing within an organization is broad and may involve topics such as the efficacy of operations, the reliability of financial reporting, deterring and investigating fraud, safeguarding assets, and compliance with laws and regulations.

Internal auditing frequently involves measuring compliance with the entity's policies and procedures. However, internal auditors are not responsible for the execution of company activities; they advise management and the Board of Directors (or similar oversight body) regarding how to better execute their responsibilities. As a result of their broad scope of involvement, internal auditors may have a variety of higher educational and professional backgrounds.

Publicly-traded corporations typically have an internal auditing department, led by a Chief Audit Executive ("CAE") who generally reports to the Audit Committee of the Board of Directors, with administrative reporting to the Chief Executive Officer.

The profession is unregulated, though there are a number of international standard setting bodies (IIA, IAASB, ISACA... Cf. paragraph standard setting below).

Contents

Other definitions

The definition above (first sentence of this page) is in essence the IIA's definition.[2] A similar definition has been developed by the accounting profession and adopted by the government auditors: the ISA 610 and the INTOSAI’s standard ("ISSAI") 1003 define the Internal audit function as "An appraisal activity established or provided as a service to the entity. Its functions include, amongst other things, examining, evaluating and monitoring the adequacy and effectiveness of internal control."

History of internal auditing

The Internal Auditing profession evolved steadily with the progress of management science after World War II. It is conceptually similar in many ways to financial auditing by public accounting firms, quality assurance and banking compliance activities. Much of the theory underlying internal auditing is derived from management consulting and public accounting professions. With the implementation in the United States of the Sarbanes-Oxley Act of 2002, the profession's growth accelerated, as many internal auditors possess the skills required to help companies meet the requirements of the law.

Standard setting bodies and/or auditors' associations

The profession is unregulated, though there are a number of international and national standard setting bodies. And in addition to institutes/boards that work on internal auditing in the large sense, there are specialized bodies which target a particular type of internal auditing.

International standard setting bodies and/or auditors' associations

National/Local internal audit bodies

The associations/institutes below are affiliated with the IIA (non exhaustive list):

Specialized audit associations and other institutions

Associations and institutions related to some aspects of internal auditing:

Internal Audit qualifications

  • IIA: Certified Internal Auditor (CIA); Certification in Control Self-Assessment (CCSA); Certified Government Auditing Professional (CGAP) for Government performance auditing and Government Auditors; Certified Financial Services Auditor (CFSA).
  • ISACA: Certified Information Systems Auditor (CISA); Certified in the Governance of Enterprise IT (CGEIT); Certified in Risk and Information Systems Control.
  • CIIA Chartered Institute of Internal Auditors: IACert, PIIA, CMIIA...

Organizational independence

To perform their role effectively, internal auditors require organizational independence from management, to enable unrestricted evaluation of management activities and personnel. Although internal auditors are part of company management and paid by the company, the primary customer of internal audit activity is the entity charged with oversight of management's activities. This is typically the Audit Committee, a sub-committee of the Board of Directors. To provide independence, most Chief Audit Executives report to the Chairperson of the Audit Committee and can only be replaced with the concurrence of that individual.

♦ According to the Institute of Internal Auditors, the Internal Auditor's obligation of Independence refers to:

  • 1) The reporting line or status of the CAE The Chief Audit Executive must report to a level within the organization that allows the internal audit activity to fulfill its responsibilities. The chief audit executive must confirm to the board, at least annually, the organizational independence of the internal audit activity (IIA standard 1110).

Organizational independence is effectively achieved when the chief audit executive reports functionally to the board (IIA practice advisory 1110A1). The board is a governing body, such as the board of directors, supervisory board, head of an agency or legislative body, board of governors or trustees of a nonprofit organization, or any other designated body of the organization, including the audit committee to whom the chief audit executive may functionally report (IIA Glossary).

  • 2) Attitude of auditors, procedures of the internal audit department. The internal audit activity must be free from interference in determining the scope of internal auditing, performing work, and communicating results (IIA practice advisory 1110A1).
  • 3) Communication right. The chief audit executive must communicate and interact directly with the Board of Directors (IIA standard 1111).

♦ According to Mautz R.K. & Sharaf H.A, American Accounting Association,[8] there are three main ways in which the auditor’s independence can manifest itself: Programming independence, Investigative independence, reporting independence. For more detail, see the wikipage Auditor independence which deals with the independence of the external auditors.

♦ The European Union is strongly in favor of "Audit committees and an effective internal control system" (8th EU Company Law Directive on Statutory Audit[9]). This 8th Directive states that "Each public-interest entity shall have an audit committee" which inter alia shall "monitor the effectiveness of the company's internal control, internal audit where applicable, and risk management systems". The European Confederation of Institutes of Internal Auditing (ECIIA)[10] and Federation of European Risk Management Associations (FERMA) also support the independence of Internal Auditing. Their guidance[11] on the 8th EU Company Law Directive states “The head of internal audit reports periodically to the board or the audit committee and to senior management on the internal audit activity’s purpose, authority, responsibility and performance relative to its plan. The main reporting line is to the audit committee.”

Regarding public institutions, the same principle of independence of internal audit applies; cf. INTOSAI’s standard GOV9140 "Internal auditor independence in the public sector” endorsed in 2010, article 9.32.[12] “The CAE should report ... to those charged with governance for strategic direction, reinforcement, and accountability. Those charged with governance (e.g. the audit committee) should safeguard the independence by approving the internal audit charter and (where applicable) the mandate."

The independence of the Internal Audit is applied by most international institutions: for instance, the European Commission audit is accountable to the Audit Progress Committee; the IBRD Auditor General reports to the president and to the audit committee comprising eight of the 24 executive directors; The IMF’s internal audit is overseen by the External Audit Committee (three members, all external and with the “accounting and financial expertise required”); The OSCE’s Office of Internal Oversight reports to the Secretariat General and the Permanent Council...

Role in internal control

Internal auditing activity is primarily directed at improving internal control. Under the COSO Framework, internal control is broadly defined as a process, effected by an entity's board of directors, management, and other personnel, designed to provide reasonable assurance regarding the achievement of objectives in the following internal control categories:

  • Effectiveness and efficiency of operations.
  • Reliability of financial reporting.
  • Compliance with laws and regulations.

Management is responsible for internal control. Managers establish policies and processes to help the organization achieve specific objectives in each of these categories. Internal auditors perform audits to evaluate whether the policies and processes are designed and operating effectively and provide recommendations for improvement.

In the United States, internal auditors may assist management with compliance with the Sarbanes-Oxley Act (SOX).

Role in risk management

Internal auditing professional standards require the function to monitor and evaluate the effectiveness of the organization's Risk management processes. Risk management relates to how an organization sets objectives, then identifies, analyzes, and responds to those risks that could potentially impact its ability to realize its objectives.

Under the COSO enterprise risk management (ERM) Framework, risks fall under strategic, operational, financial reporting, and legal/regulatory categories. Management performs risk assessment activities as part of the ordinary course of business in each of these categories. Examples include: strategic planning, marketing planning, capital planning, budgeting, hedging, incentive payout structure, and credit/lending practices. Sarbanes-Oxley regulations also require extensive risk assessment of financial reporting processes. Corporate legal counsel often prepares comprehensive assessments of the current and potential litigation a company faces. Internal auditors may evaluate each of these activities, or focus on the processes used by management to report and monitor the risks identified. For example, internal auditors can advise management regarding the reporting of forward-looking operating measures to the Board, to help identify emerging risks.

In larger organizations, major strategic initiatives are implemented to achieve objectives and drive changes. As a member of senior management, the Chief Audit Executive (CAE) may participate in status updates on these major initiatives. This places the CAE in the position to report on many of the major risks the organization faces to the Audit Committee, or ensure management's reporting is effective for that purpose.

Internal auditors may help companies establish and maintain Enterprise Risk Management processes.[13][14] Internal auditors also play an important role in helping companies execute a SOX 404 top-down risk assessment. In these latter two areas, internal auditors typically are part of the risk assessment team in an advisory role.

Role in corporate governance

Internal auditing activity as it relates to corporate governance is generally informal, accomplished primarily through participation in meetings and discussions with members of the Board of Directors. Corporate governance is a combination of processes and organizational structures implemented by the Board of Directors to inform, direct, manage, and monitor the organization's resources, strategies and policies towards the achievement of the organizations objectives.[15] The internal auditor is often considered one of the "four pillars" of corporate governance, the other pillars being the Board of Directors, management, and the external auditor.[16]

A primary focus area of internal auditing as it relates to corporate governance is helping the Audit Committee of the Board of Directors (or equivalent) perform its responsibilities effectively. This may include reporting critical internal control problems, informing the Committee privately on the capabilities of key managers, suggesting questions or topics for the Audit Committee's meeting agendas, and coordinating carefully with the external auditor and management to ensure the Committee receives effective information.

Nature of the internal audit activity

Based on a risk assessment of the organization, internal auditors, management and oversight Boards determine where to focus internal auditing efforts (the focus prioritization is part of the annual/multi-year audit planning; usually, the audit plan is proposed by the Chief Internal Audit (sometimes with several options or alternatives) to the approval of the Audit Committee or Board of Directors). Internal auditing activity is generally conducted as one or more discrete assignments. A typical internal audit assignment [17] involves the following steps:

  1. Establish and communicate the scope and objectives for the audit to appropriate management.
  2. Develop an understanding of the business area under review. This includes objectives, measurements, and key transaction types. This involves review of documents and interviews. Flowcharts and narratives may be created if necessary.
  3. Describe the key risks facing the business activities within the scope of the audit.
  4. Identify control procedures used to ensure each key risk and transaction type is properly controlled and monitored.
  5. Develop and execute a risk-based sampling and testing approach to determine whether the most important controls are operating as intended.
  6. Report problems identified and negotiate action plans with management to address the problems.
  7. Follow-up on reported findings at appropriate intervals. Internal audit departments maintain a follow-up database for this purpose.

Audit assignment length varies based on the complexity of the activity being audited and Internal Audit resources available. Many of the above steps are iterative and may not all occur in the sequence 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.

Internal audit reports

Internal auditors typically issue reports at the end of each audit that summarize their findings, recommendations, and any responses or action plans from management. An audit report may have an executive summary; a body that includes the specific issues or findings identified and related recommendations or action plans; and appendix information such as detailed graphs and charts or process information. Each audit finding within the body of the report may contain five elements, sometimes called the "5 C's":

  1. Condition: What is the particular problem identified?
  2. Criteria: What is the standard that was not met? The standard may be a company policy or other benchmark.
  3. Cause: Why did the problem occur?
  4. Consequence: What is the risk/negative outcome (or opportunity foregone) because of the finding?
  5. Corrective action: What should management do about the finding? What have they agreed to do and by when?

The recommendations in an internal audit report are designed to help the organization achieve its goals, which may relate to operations, financial reporting or legal/regulatory compliance. They may relate to effectiveness (i.e., whether goals were met or compliance with standards was achieved) or efficiency (i.e., whether the outputs were generated with minimum inputs).

Audit findings and recommendations also relate to particular assertions about transactions, such as whether the transactions audited were valid or authorized, completely processed, accurately valued, processed in the correct time period, and properly disclosed in financial or operational reporting, among other elements.

Developing the plan of engagements

Internal auditing standards require the development of a plan of audit engagements (assignments) based on a risk assessment, updated at least annually. The input of senior management and the Board is typically included in this process. Many departments update their plan of engagements throughout the year as risks or organizational priorities change.[18]

This effort helps ensure the audit activity is aligned with the organization’s objectives, by answering two key questions: First, what goals is the organization trying to accomplish in the upcoming period? Second, how can the Internal Audit Department assist the organization in achieving these goals?

Internal auditors often conduct a series of interviews of senior management to identify potential engagements. Changes in people, processes, or systems often generate audit project ideas. Various documents are reviewed, such as strategic plans, financial reports, consulting studies, etc. Further, the results of prior audits and resolution of open issues are considered. For example, automated programs such as NEMEA Compliance Center can collect responses, produce and write standardized compliance reports for an organization seeking or issuing compliance rules. Even if a business area is important, prior audit work and the nature and status of open issues may render further audit effort unnecessary. If the organization has a formal enterprise risk management (ERM) program, the risks identified therein help limit the amount of separate risk assessment performed by Internal Audit.

The preliminary plan of engagements is documented and prioritized. Audit resources and expertise are then considered and a final plan is presented to senior management and the Audit Committee. The presentations vary based on the needs of the stakeholders and may include the following:

  • Summary of key goals, risks and corresponding major audits, to illustrate alignment;
  • Analyses of audit effort along a variety of dimensions (e.g., by business segment, COSO objective category, IT, Sarbanes-Oxley, vs. prior year, etc.) along with commentary regarding changes;
  • Brief description of critical potential audit engagements identified;
  • Audit engagements requested but not planned for execution due to prioritization and resources;
  • Required co-sourcing effort, typically where outside expertise is required or during peak periods;
  • Coordination with other risk functions, such as legal, compliance or insurance, to ensure coverage of key organizational risks;
  • Update on audit staffing levels, experience and certification; and
  • Appendix materials, such as planning approach, assumptions (e.g., days per auditor and staffing level) and brief descriptions of all planned audits and related prioritization.

Best Practices in Internal Auditing

Measuring the internal audit function

The measurement of the internal audit function can involve a balanced scorecard approach.[19] Internal audit functions are primarily evaluated based on the quality of counsel and information provided to the Audit Committee and top management. However, this is primarily qualitative and therefore difficult to measure. “Customer surveys” sent to key managers after each audit engagement or report can be used to measure performance, with an annual survey to the Audit Committee. Scoring on dimensions such as professionalism, quality of counsel, timeliness of work product, utility of meetings, and quality of status updates are typical with such surveys. Understanding the expectations of senior management and the audit committee represent important steps in developing a performance measurement process, as well as how such measures help align the audit function with organizational priorities.[20]

Quantitative measures can also be used to measure the function’s level of execution and qualifications of its personnel. Key measures include:

Plan completion: This is a measure of the degree to which the annual plan of engagements is completed, measured at a point in time. This may be measured using the number of audit engagements completed, weighted by the planned size of each assignment, with estimates for audits in-progress. Measured throughout the year, it is compared against the percentage of the year elapsed.

Report issuance: This is a measure of the time elapsed from completion of testing to issuance of the final audit report, including management’s action plans. This can be measured in average days or percentage of reports issued within a certain standard, such as 30 days. Establishing expectations for the timing of management’s response to report recommendations is critical. In addition, the scope and degree of change involved in the report’s action plans are key variables. For example, a report for a single retail store requiring only the store manager’s action might take 3–5 days to issue. However, a report consolidating findings from 20 retail stores, with action plans with national implications determined by top management, may take 30–60 days in complex organizations.

Issue closure: Reported audit findings are often called “issues” or “deficiencies.” Professional standards require audit functions to track reported findings to resolution, which effectively requires the maintenance of an issues follow-up database. The number of days that reported issues remain open, or open after their agreed-upon closure date, are key measures. In addition, reporting database statistics such as the number of issues open (unresolved), closed (resolved), and issues opened/closed during a given period are useful statistics.

Staff qualifications: This can be measured through the percentage of staff with professional certifications, graduate degrees, and overall years of experience.

Staff utilization rate: This is measured as the percentage of time spent on audit engagements, as opposed to administrative time such as training or vacation. Many internal audit departments track time by audit engagement. This is typically captured in a database or spreadsheet.

Staffing level: The number of positions filled relative to the authorized staffing level. Due to the challenge of finding qualified staff, departments may have rotational programs to bring in management to complete tours in the function or be "guest" auditors. Audit departments also "co-source," meaning they obtain contract auditors from service providers.

Developing and retaining staff

Developing and retaining quality professionals is a key concern in the profession.[21] Key methods for developing and retaining internal audit staff personnel include:

  • Providing challenging, varied assignments
  • Ensuring quality supervision
  • Ensuring staff participates in audit engagements from start to finish, to learn all phases of the audit process
  • Providing opportunities to lead (in-charge) assignments, starting with more structured engagements such as Sarbanes-Oxley work
  • Participating on departmental improvement task forces, such as preparation for quality assurance review
  • Participating in the recruiting and interviewing process for new hires
  • Rotating through various audit teams (in larger departments) or audits of various businesses
  • Providing both outside training (e.g., seminars) and in-house training (e.g., company systems) for two weeks/year
  • Participation in annual risk assessment activities, whether asking key questions or just taking notes

Reporting of critical findings

The Chief Audit Executive (CAE) typically reports the most critical issues to the Audit Committee quarterly, along with management's progress towards resolving them. Critical issues typically have a reasonable likelihood of causing substantial financial or reputational damage to the company. For particularly complex issues, the responsible manager may participate in the discussion. Such reporting is critical to ensure the function is respected, that the proper "tone at the top" exists in the organization, and to expedite resolution of such issues. It is a matter of considerable judgment to select appropriate issues for the Audit Committee's attention and to describe them in the proper context.

References

  1. ^ IIA's definition of audit.
  2. ^ "IIA definition of Internal Audit". IIA. http://www.theiia.org/guidance/standards-and-guidance/ippf/definition-of-internal-auditing/. Retrieved 25 March 2011. 
  3. ^ IIA Website-Standards
  4. ^ IIA Website
  5. ^ [1] Official website of the International Federation of Accountants, IAASB
  6. ^ http://www.iia.org.uk/
  7. ^ http://www.iema.net
  8. ^ Mautz R.K. & Sharaf H.A (1961) ‘The Philosophy of Auditing’, American Accounting Association. & Dunn, J., 1996. Auditing Theory and Practice. 2nd ed. Prentice Hall
  9. ^ 8th European Company Law Directive on Statutory Audit = Directive 2006/43/EC of the European parliament and of the Council of 17/5/2006 on statutory audits of annual accounts http://eur-lex.europa.eu/LexUriServ/LexUriServ.do?uri=OJ:L:2006:157:0087:0087:EN:PDF
  10. ^ http://www.eciia.eu/
  11. ^ "ECIIA and FERMA's Guidance for boards and audit committees on the implementation of Art 41.2 of the 8th EU Directive on the 8th EU Company Law Directive". ECIIA and FERMA's Guidance for boards and audit committees on the implementation of Art 41.2 of the 8th EU Directive on Company Law. ECCIA. http://www.eciia.eu/system/files/eccia_ferma_web_1.pdf. Retrieved 30 March 2011. 
  12. ^ http://www.issai.org/composite-194.htm INTOSAI Guidance for Good Governance (INTOSAI GOV), GOV9140 Internal Audit Independence in the Public Sector
  13. ^ Role of Internal Auditing in ERM
  14. ^ KPMG Evolution of Risk and Control
  15. ^ Rezaee, Zabihollah. Financial Statement Fraud: Prevention and Detection. New York: Wiley; 2002.
  16. ^ IIA Article "Getting a Leg Up"
  17. ^ More details and examples can be obtained from http://www.internalaudit.biz
  18. ^ Picket, K.H. Spencer “Audit Planning – A Risk Based Approach”. The Institute of Internal Auditors. Wiley. New Jersey: 2006.
  19. ^ Frigo, Mark L. A Balanced Scorecard Framework for Internal Auditing Departments. IIA Research Foundation. Altamonte Springs, FL.: 2002
  20. ^ IIA-GAIN Study-Knowledge Report-Measuring Internal Audit Performance-September 2009
  21. ^ State of the IA Profession Survey 2008

Institute of Internal Auditors - UK and Ireland


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