Techniques for Improving Internal Auditing Quality

Dr.Shaio Yan Huang, Associate Professor ,Department of Accounting, Feng Chia University,

Dr. Yu-Chih Lin, Associate Professor ,Department of Accounting, Feng Chia University

Dr. F. Barry Barnes, Professor and Chair of Leadership, H. Wayne Huizenga School of Business & Entrepreneurship, Nova Southeastern University

Mr. Cheng Tsung Lu, Doctoral Student, Department of Business Administration, National Dong Hwa University

Abstract

Since the financial failures of Enron and WorldCom sent shocks waves through the accounting profession and business community around the world, internal control and auditing are receiving considerable attention in the business world. This paper introduces seven factors affecting internal audit efficiency: 1) revise auditing structure, 2) improve auditing techniques, 3) make sound auditing plans, 4) computerize the auditing process, 5) implement value-added suggestions, 6) coordinate external auditors, and 7) comply with legal requirements.

Introduction

In the era of the knowledge-based economy, developing a core competence for internal control can be a crucial factor for sustaining a profitable business and consolidating corporate governance. Since the financial failures of Enron and WorldCom sent shock waves through the accounting community and corporations around the world, internal control and auditing have again become the center of attention in the business world. Prior to WorldCom’s bankruptcy scandal of 2002, the company’s internal auditor, Cynthia Cooper, had reported to top management that the company’s financial statements were unreliable. Yet top management did not address this concern, eventually causing their corporate bankruptcy (Kelly, 2002; Hymowitz, 2002). On the other hand, even though some companies’ internal auditing departments are well established, internal auditors can still face challenges and setbacks when they execute their work. This can come from resistance by other departments as well as the internal auditors’ limited knowledge about specific operational details, and this can stunt their capacity to ascertain the nature of problems or to check for inaccuracy or flaws in reporting (Homer & Holdren, 2001). Thus the quality of internal auditing has sometimes been short of meeting standards. In an effort to avoid a repeat of such financial debacles and promote the status of internal auditors, this paper attempts to address several factors that can improve the internal auditing quality of companies.

Defining Internal Auditing Efficiency

According to the COSO Report (1992), monitoring – an important element in internal control systems – is defined as the evaluation of the design of internal control and the effectiveness of its execution. Besides monitoring by management and the board of directors, a company should have its own independent mechanism of internal auditing activities. The purpose of these internal auditing activities is to ensure the effectiveness of the company’s control mechanism by evaluating activities and providing control management. Efficiency is generally defined as the crucial element for corporations to gain profits and make financial plans based on the concepts of input and output as well as added value. Greenwald (1990) suggested efficiency and effectiveness are two necessary elements for internal auditing efficiency, which is to do the right things in the right way. That is,

efficiency + effectiveness = internal auditing quality.

Walz (1997) described how internal auditors are able to provide added value when they increase internal auditing efficiency and complete the same tasks using fewer resources. Hence, auditing quality relies not simply on an input-output or a cost-effect relationship, but on the added value of internal auditing as well as the efficiency and effectiveness of internal auditing.

Techniques for improving internal auditing quality

The function of internal auditing has slowly evolved from the role of simply detecting a company’s error and fraud to one of consulting (Aldhizer & Cashell, 2000; Richards, 2001; Nagy & Cenker, 2002). This paper will identify techniques that can change the internal auditor’s role from a passive inspector to an active participant usually associated with management consulting. Through internal auditing, companies cannot only eliminate non-value added activities, but also comply with business process reengineering and enterprise resource management. Hence, it is also a goal of this paper to create an understanding of the factors for improving internal auditing quality in order to increase the effectiveness and efficiency of auditing and the capacity for creating value-added activity. These techniques can help the CEO and general managers to understand the real purpose of internal auditing: increasing trust in the function of their internal auditing department. Figure 1 offers seven techniques for improving internal auditing quality.

Figure 1: Seven techniques for improving internal auditing efficiency

(1) Revise auditing structure:

The best way to increase auditing quality is to execute auditing plans and techniques proficiently. The key points of proficiency rely on appropriate supervision and quality of auditors, including their recruitment and appropriate training. The Internal Auditing Association’s professional ethics standards clearly describe the internal auditor’s professional capacity as encompassing professional knowledge and technique, continuous education, and maintaining independence.

(2) Improve auditing techniques:

Sometimes, simple innovations will make auditing assignments more effective. An obvious reform to auditing quality would be to adopt the auditing procedure from the COSO framework which includes five tasks: control environment, risk evaluation, control activities, monitoring, information, and communication. This aspect is concerned with whether the internal auditing department should exercise control self assessment and auditing control environment (i.e. organizational culture and management style).

(3) Make sound auditing plans:

Making plans and statements based on vision, mission, and strategies can maximize auditing effectiveness. This factor concerns whether there are any auditing instructions and plans instituted in the internal auditing department, and the auditing plan should combine an internal control system with the firm’s strategies.

(4) Computerize auditing processes

A successful auditing task force knows how to utilize techniques and knowledge to create value; for example, the use of computer-assisted audit techniques (i.e. data mining) instead of the traditional transaction test. Top management must also support the internal auditing department for purchasing appropriate auditing software.

(5) Implement value-added suggestions

For internal auditors, the final product is an internal auditing report or auditing suggestion report. Internal audit reports should add value beyond traditional audit reports. That is, the function of audit reports should include not only monitoring and detecting defects and fraud as done in the traditional audit report, but also provide innovative recommendations to help business process reengineering. The suggestions in the auditing report should have both a prevention function and a proactive vision.

(6) Coordinate external auditors

One component of corporate governance’s external mechanism is the provision of financial statements’ notarization to ensure fair financial statements. However, auditing tasks between internal and external auditors have many redundancies (i.e. taking stock, financial auditing). Therefore, the coordination between external auditing and internal auditing is important to avoid unnecessary overlapping of assigned functions as well as gaps where tasks are left unassigned.

(7) Comply with legal requirements

Pae and Yoo (2001) argued that enforcing auditors’ legal liability is one way to improve auditing quality. Many countries, including Australia in 1990 and Canada in 1993, have passed legislation to regulate internal auditing, such as establishing internal auditing departments, developing auditing criteria, implementing training programs, allocating resources, and expanding auditing areas. They also passed legislation for publicly held and above companies to set up internal auditing mechanisms and explicitly mark off specific responsibilities between auditors and stakeholders. Top managers issue the internal control statement in accordance with the auditing report. The statement should be published in an annual report to government. In this way, the legislation is able to improve auditing efficiency by influencing auditing procedures and auditor’s attitudes.

Conclusion

Since Time magazine’s selection of Cynthia Cooper, the WorldCom’s internal auditor, as one of the leading persons for the year of 2002, internal auditing has been given enormous importance. A case can be made that the biggest bankruptcy scandal ever seen in modern history might have been avoided if WorldCom’s top management had recognized the tremendous impact of internal audit reports on its day-to-day operations. Thus internal auditors should not narrow their role simply to the discovery of the weaknesses of internal control, but should actively promote themselves as an integral and necessary part of the managerial function.

Internal auditing can enhance problem-solving when a company utilizes it to promptly identify internal difficulties such as an inconsistency between information systems and operating procedures and immediately offer suggestions for working problems out. In order to improve internal auditing efficiency including the recruitment of auditing specialists (e.g., computing and managerial professionals), a company can apply COSO’s framework for auditing the company’s existing strategy, computerize the auditing process, and provide value-added suggestions. Finally, a company must carefully coordinate assignment of audit tasks for external auditors in order to avoid gaps or overlaps.

Certainly government’s efforts to regulate the execution of internal auditing places an additional requirement on companies to both emphasize and support their internal auditing function. In summary, until companies, government and related internal auditing mechanisms more precisely perform their own specific tasks, the reduction of fraud and future bankruptcy scandals is unlikely. Applying the seven techniques described above will, hopefully, aid in improving internal auditing quality and allow more effective and efficient auditing processes that add value.

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