Yearend Internal Auditing: Case Study Example

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Table of Contents

Audit Case Study: Introduction
Overview of the newly formed XYZ Company
Value of auditing to XYZ Ltd
Advantages of appointing the same auditors
Disadvantages of appointing the same auditors
Advantages of audit rotation
Disadvantages of audit rotation
Audit Case Study: Conclusion
References

Audit Case Study: Introduction

Auditing is the process of examining the financial statements of an organization, correcting errors, and eliminating possible cases of fraud. The auditing process is a core activity that enables a company to control its internal activities in an efficient manner. Through auditing, most companies are able to achieve their business goals and objectives (Wang & Tuttle 2009).

Several critics have risen concerning the auditing process. While some businesspersons find it worthwhile to invest in the auditing exercise, some find the auditing exercise unworthy.

In this case, we have the XYZ Ltd Company; a pharmaceutical manufacturing company that was formed because of the splitting of the parent company, ABC Ltd. XYZ Ltd is the smaller of the two newly formed companies and the previous sales manager of the parent company is the Managing Director.

The managing director does not find it worthwhile for the small company to carry out yearend audits. According to him, yearend auditing is an unnecessary exercise that will only increase the expenses of the company without necessarily adding value to the business.

This paper will give a stringent analysis of the newly formed XYZ Company and determine if indeed there is a need to carry out yearend auditing. The paper will also give a detailed discussion of the pros and cons of appointing the same auditors of the parent company to audit XYZ Ltd.

Lastly the paper will give an overview of the audit rotation exercise, its advantages and disadvantages. From the discussions, the paper will give decisive conclusions and recommendations that would enable the XYZ Company’s managers to make a worthwhile decision concerning the auditing process.

Overview of the newly formed XYZ Company

As indicated, XYZ Ltd Company formulated because of the splitting of the parent company. According to the previous descriptions, XYZ Ltd Company is a private limited company that is not legally obliged to have an audit (Hodgdon et al. 2009).

This is because the company Act only obliges state owned companies and public limited companies to have audited financial records, whereas, the smaller companies voluntarily choose to have auditors examining their financial statements. However, although having an audit is not a mandatory requirement for XYZ Ltd, the auditing exercise would add some tangible value to the company.

Value of auditing to XYZ Ltd

Detection and prevention of fraud

Fraud is a practice that can make businesses to undergo some massive losses. It is noteworthy that a small company like XYZ has a small operating capital that could diminish drastically if not well managed. Fraud cases such as skimmed payments from customers, cash theft, improper handling of petty cash and misuse of the company’s credit cards are some of the practices that can lead to total failure of a company.

It is quite expensive for a small business like XYZ Ltd to create an internal audit department, however, the company can create a system that checks and controls the financial operations and the company employees. An informal internal audit process would somewhat reduce fraud cases resulting from personal interests (Chi & Huang 2011). It is noteworthy that the parent company would have split due to extreme cases of fraud.

Prevention of fraud through an informal audit exercise would enable the small XYZ Company to prosper and grow into a big multinational company and even surpass the projected turnover of £2.8 million in the first year of trading.

It is important for the company to create a program that would help in monitoring employees and enforce strict rules regarding any employee who is found guilty of committing fraud cases. The establishment of an internal audit would facilitate the above-mentioned practices though a persistent analysis of the company’s operations.

Testing and monitoring of internal controls

An Informal internal audit calls for recurrent analysis of the operations within a company. The habitual analysis enables the company’s operations to occur smoothly, where, the employees are kept on toes to offer the best of services. A small company like XYZ Ltd can employ auditors who would design, modify, and control the internal activities of the company.

Though auditing, the company is able to streamline its activities in a manner that would enable it to achieve its goals and objectives (Holm & Zaman 2012). Essentially, XYZ Ltd is a profit making company that would aim at generating the maximum profits possible.

The auditing exercise would enable the company to keep track of its revenue and expenditure and the gross profits made during a particular financial year. Any form of misappropriation of resources is tracked, where; all the involved stakeholders are made answerable of their actions.

Monitoring the company’s compliance with the company policies

All companies have policies that guide then in their daily operations. In addition to the informal internal exercise, XYZ Ltd Company can employ a formal internal audit policy that works towards ensuring the company eliminates all actions that would expose it to massive losses. A company may have a policy that extends credit to its customers to prevent losses.

An auditing exercise will determine if indeed the company adheres to the policy. Moreover, the auditors will be able to carry out a cost benefit analysis of the credit policy and determine if it is a worthwhile practice. The reports from the auditors will help the decision makers to determine new policies that would work if enforced and identify the old policies to eliminate from the company practices (Deis & Giroux 2006).

An operational audit would examine the financial statements of a business to ensure the business complies with the policies of obtaining maximum efficiency from all business operations.

Monitoring the company’s compliance with the government regulations

The worst thing that can happen to a small business like XYZ Ltd is facing the adverse consequences of failing to adhere to government regulations. An operational audit exercise plays a great role in advising the business managers of all the applicable government regulations (Bon Kim & Yi 2009).

It is though an auditing process that a business would know the legal procedures of tax avoidance. Moreover, the government has strict employment laws that companies ought to follow.

The auditing exercise would advise the management team accordingly on when it should recruit new employees, when to promote or when to fire an incompetent employee. The auditors would advise the management team of the actions that attract fines as well as the procedures to obtain and comply with government regulations.

The exercise of appointing an auditor

The exercise of appointing an auditor may seem very simple, but it is associated with a lot of dilemma. The XYZ Company formed because of the splitting of the parent company.

There is no clear reason as to why the parent company decided to separate the pharmaceutical and optical divisions; however, it would be due to mismanagement reasons. Whatsoever the reason, appointing the same auditors as those of the parent company to audit XYZ Ltd Company is associated with several advantages and disadvantages.

Advantages of appointing the same auditors

Massive experience and expertise

As indicated, the auditors have audited the financial records for the parent company for the past ten years. This is a clear indication that the auditors did some marvelous work that sustained the growth and expansion of the parent company (Jackson, Moldrich & Roebuck 2010). There is a high probability that the parent company had grown too big such that the managers decided to split it for easy management.

The success of the parent company is attributed to the massive experience and the excellent work of the auditors. Similarly, XYZ Ltd Company can appoint the same experienced auditors to audit their financial records.

Appointing the same auditors would be an assurance that the newly formed company would grow and last for the next 10 years or more. XYZ Ltd Company will greatly benefit from the quality services from the expertise of the auditors.

Affordability and efficiency of the auditing services

It is evident that a small business like XYZ Ltd will find it very expensive to obtain new auditors to audit their financial books (Kaplan & Mauldin 2010). The auditors of the parent company may have some compassion with the small company and charge the company some affordable rates for the auditing exercise.

Moreover, the auditors who are already familiar with the financial records of the parent company will give an effective allocation of the amount set aside for the auditing expense to ensure that the company does not run at a loss.

Smooth flow of activities

Bringing in a new set of auditors would somewhat bring in disruptions. If XYZ Ltd Company appoints the same auditors as the parent company, the auditors will put up with the small company easily.

In fact, maintaining the same auditors would enhance their morale to improve their quality of services in the subsequent audits (David & Thomas 2013). The relationship between the auditors and the company would strengthen, and this would make the auditors to work hard to ensure their auditing work brings in some mutual benefit to all the company stakeholders.

Disadvantages of appointing the same auditors

Possibility of recurring previous mistakes

From a business point of view, an esteemed company cannot decide to separate its operations for any good reasons. There is a very high probability that the company decided to do so because it began experiencing some massive losses because of vague auditing processes.

If truly this is the reason behind the splitting of the company, it means that the auditors played a critical role in bringing down the parent company. Therefore appointing the same auditors will pose the way to recurring the previous mistakes. In the end, the XYZ Ltd Company would also face the same problem and it may end up collapsing.

Lack of the point of comparison and evaluation

It is always advisable for companies to evaluate and compare the services offered by a particular company stakeholder. If XYZ Ltd Company uses the same auditors as the parent company, it may not be able to evaluate the efficiency of the services. While the auditors may appear to offer quality services, it would be worthwhile to have a change that would formulate a point of comparison.

Probably, the new auditors would reveal fraud cases that the usual auditors would not depict. In essence, appointing the same auditors as those of the parent company will blindfold the XYZ Company and it may not be able to gauge the quality of the auditing services (Kramer et al. 2011).

Audit rotation

The exercise of changing auditors has often raised eyebrows amongst businesspeople. While some businesspersons regard audit rotation as a worthwhile practice, some of them regard the exercise as unworthy as it only encourages businesses to doubt the competence of auditors. Despite the different perceptions, audit rotation is associated with various advantages and disadvantages.

Advantages of audit rotation

Increased perfection

It is evident that there is no perfect human being; therefore, a different set of eyes on a company’s financial record would detect an error that the preceding auditors could not detect. In fact, for publicly held companies, audit rotation is done every five years, and private limited companies can employ the same practice to obtain quality audit services.

The exercise helps in identifying and eliminating intentional and non-intentional errors (Daniels & Booker 2011). Companies that embrace audit rotation will be at a safe position, as they would provide clear records of their financial statements to the bank and to the funders.

Decreased fraud and increased impartiality

Some auditors within a given audit firm may collaborate with the financial managers of a given company to “steal” from the company. Audit rotation plays a significant role in ending such cases because not all auditors would comply with such evil deals.

The shortened period of auditing will not allow audit firms to create close relationships with the management, an action that may have a negative impact on the performance of the auditors.

Audit rotation enhances the provision of impartial services by audit firms as they are obligated to rotate the auditors within the firm (Chi et al. 2009). In essence, the audit rotation exercise plays a critical role in increasing impartiality for all the stakeholders of the company.

Disadvantages of audit rotation

Disruption of the company’s activities

It is evident that audit rotation, especially if it involves changing the auditing firm would have adverse consequences on the company’s activities. Different audit firms will come up with different advisories to the management team and the company’s activities may be disrupted from one time to another (Bates et al. 2012).

Moreover, audit rotation does not allow the development of a long-term relationship between the company and the auditors, which is very important for the delivery of efficient services.

Destroyed reputation of the company

Some companies have had a tendency of frequently changing the auditing firms. The practice of changing audit firms too often would depict a negative picture of the firm. Investors would shy away from such firms, as they would perceive them as incompetent because they only do “auditor shopping” and expect better results instead of working of their performance.

In essence, audit rotation would bring out misconceptions about a profit making organization like XYZ Ltd Company.

Increased risk of audit failure

It is evident that every time a new audit firm is appointed to carry out the auditing exercise, the firm requires some time to comprehend the company’s books of accounts. The audit firm fully understands the rules of the game of how to audit the firms accounting books when its term is almost over.

The administrative will have to invest time to evaluate the subsequent audit firm and the whole exercise is not only expensive, but it also increases the chances of failure of the auditing exercise by the new audit firm (Daugherty et al. 2013).

Audit Case Study: Conclusion

From the discussions, it is evident that auditing is a very essential exercise in any organization. Auditing enables companies to have a clear outlay of the company’s activities. Though auditing, a company can easily depict fraud cases and address them accordingly. From the discussions, it is evident that the decision on whether to maintain auditors or to employ an audit rotation depends on their performance.

If, for example, the auditors of the parent company, ABC Ltd Company, were not competent, the newly formed XYZ Ltd Company may need to appoint a new auditor to audit the financial books. Secondly, if the new set of auditors do not display their competence after a couple of years, an audit rotation will be essential (Peecher, Schwartz & Solomon 2011).

In essence, every decision made is associated with advantages and disadvantages. The company managers are obliged to make decisive decisions about the auditing process. There should be strong reasons behind any form of changes in the auditing process.

Both the internal and external auditors have a great role in maintaining efficient and reliable financial reports. The auditors should be in a position to give a detailed explanation of every figure that appears in the financial records.

The directing managers should only take the role of the overseers who should only come in whenever there are suspicions of fraud cases. All scandals relating to the books of accounts are handled in a professional manner without downsizing the involved stakeholders.

References

Bates, HL, Waldrup, BE, Jaeger, DG & Shea, V 2012, ‘Issues with mandatory audit firm rotation’, Journal of Business and Accounting, vol. 5, no. 1, pp. 70-75.

Bon Kim, J, & Yi, CH 2009, ‘Does auditor designation by the regulatory authority improve audit quality? Evidence from Korea’, Journal of Accounting and Public Policy, vol. 28, no. 3, pp. 207-230.

Chi, W & Huang, H 2011, ‘Discretionary accruals, audit-firm tenure and audit-partner tenure: empirical evidence from Taiwan’, Journal of Contemporary Accounting & Economics, vol. 1, no. 1, pp. 65-92.

Chi, W, Huang, H, Liao, Y, & Xie, H 2009, ‘Mandatory audit partner rotation, audit quality, and market perception: evidence from Taiwan’, Contemporary Accounting Research, vol. 26, no. 2, pp. 359-391.

Daniels, W & Booker, Q 2011, ‘The effects of audit firm rotation on perceived auditor independence and audit quality’, Research in Accounting Regulation, vol. 23, no. 1, pp. 78-82.

Daugherty, B, Dickins, D, Hatfield, R, & Higgs, J 2013, ‘Mandatory audit partner rotation: perceptions of audit quality consequences’, Current Issues in Auditing, vol.7, no.1, pp. 30-35.

David SJ &Thomas, EV 2013, ‘Audit firm rotation and audit quality: evidence from academic research’, Accounting Research Journal, vol. 26, no.1, pp.75-84.

Deis, DR, & Giroux, G 2006, ‘The effect of auditor changes on audit fees, audit hours, and audit quality’, Journal of Accounting and Public Policy, vol. 15, no. 1, pp. 55-76.

Hodgdon, C, Tondkar, RH, Adhikari, A & Harless DW 2009, ‘Compliance with international financial reporting standards and auditor choice: new evidence on the importance of the statutory audit’, The International Journal of Accounting, vol. 44, no.1, pp. 33-55.

Holm, C & Zaman M 2012, ‘Regulating audit quality: restoring trust and legitimacy’, Accounting Forum, vol. 36, no. 1, pp. 51-61.

Jackson, AB, Moldrich, M & Roebuck, P 2010, ‘Mandatory audit firm rotation and audit quality’, Managerial Auditing Journal, vol. 23, no. 5, pp. 420-437.

Kaplan, SE & Mauldin EG 2010, ‘Auditor rotation and the appearance of independence: evidence from non-professional investors’, Journal of Accounting and Public Policy, vol. 27, no. 2, pp. 177–192.

Kramer, ST, Georgakopoulos, G, Sotiropoulos, N & Vasileiou, KZ 2011, ‘Audit firm rotation, audit firm tenure and earnings conservatism’, International Journal of Business and Management, vol. 6, no. 8, pp. 44-57.

Peecher, ME, Schwartz, R & Solomon, R 2011, ‘It is all about audit quality: perspectives on strategic-systems auditing’, Accounting, Organizations and Society, vol. 32, no. 5, pp. 463-485.

Wang, KJ & Tuttle, BM 2009, ‘The impact of auditor rotation on auditor-client negotiation’, Accounting, Organizations and Society, vol. 34, no. 2, pp. 222–243.

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