Auditing: Importance, Types, and Benefits

1. Chapter 15 C H A P T E R 15 Auditing

2. Chapter Objectives • Define the purposes of auditing. • Understand the problems associated with poor auditing. • Describe the types of audits. • Understand the importance of selecting competent and unbiased auditors. • Understand how the auditing process works. • Understand how sport fraud can occur through sloppy financial analysis.

3. Purposes of Auditing • There are two fundamental roles: • Auditing ensures that all financial statements accurately portray a firm’s financial position. • Audits allow managers to analyze their operation’s efficiency. (continued)

4. Purposes of Auditing (continued) • The purpose of auditing is to investigate and determine if the financial statements produced by a business have been prepared in accordance with appropriate financial reporting practices. • The reason for bankruptcies, financial hardships, and poor investments can often be tracked to a lack of diligence in monitoring, spending, and investing money. (continued)

5. Purposes of Auditing (continued) • Auditors study the entire business. • Often entails analyzing a business’ internal processes to see whether they successfully control the flow of financial information • Auditing is designed to identify problems and to ensure investor confidence in a company’s financial statements. • Audits may detect areas in which a business could operate more efficiently, which could lead to an increase in profits.

6. Types of Audits • Internal Audit • Completed by staff members within a business • Involved in preparing an organization’s financial statements to ensure their accuracy • Involved in the establishment of internal controls for the organization • Independent Audit • An external review of the finances by people who are not directly involved with the documents being reviewed • Can also be performed by external entities, such as public accounting firms, that can verify the truthfulness of the documents being reviewed

7. Independent Audits: Types

8. Independent Audits: Benefits • Benefits primarily for auditees • Independent audits provide credibility and reliability to financial statements. • Audits dissuade management and employees from committing acts of fraud. • Audited financial statements lessen the likelihood of government audits by ensuring that the basis for the preparation of tax returns and other financial documents is accurate. • Audited financial statements increase investor or creditor confidence and broaden the sources of outside financing. • Independent audits uncover errors in the auditee’s financial records, which may lead to the recovery of lost revenue or may decrease costs. • Independent audits ensure that the business is consistently following stated policies and procedures. (continued)

9. Independent Audits: Benefits (continued) • Benefits primarily for external members of the business community • Audited financial statements give vendors and other creditors a credible basis for making decisions about extending credit. • Audited statements are a credible basis on which potential and current investors can evaluate investment and management performance. • Audited statements provide insurance companies a credible and accurate basis for settling claims for insurance-covered losses. • Audited statements provide labor unions and the auditee an objective basis on which to settle disputes over wages and fringe benefits. • Audited statements provide the buyer and seller a basis for negotiating the terms for the sale or merger of business entities. (continued)

10. Independent Audits: Benefits (continued) • Benefits primarily for government entities and the legal community • Government agencies gain additional assurance concerning the dependability and accuracy of tax returns and financial reports. • Independent audits of financial statements from public interest organizations such as banks and public utilities provide government agencies with an independent means to focus their special examination resources. • Audited financial statements give the legal community an independent basis for settling bankruptcy actions.

11. Concepts Within Auditing • Materiality: The levels of misstatement that are allowable in financial information. • No financial system is perfect, and misstatements do occur. • A misstatement can be considered material if knowledge of the misstatement affects a decision made by a reasonable user of the statements. • A misstatement that is relatively small or one that does not affect the overall fairness of the financial statements is considered immaterial. (continued)

12. Concepts Within Auditing (continued) • Internal controls: The processes and mechanisms used in the management of a business to ensure accuracy. • Example: • A sporting venue has a large parking lot, and two employees help process people through the gates. • To guarantee accuracy, the venue employs a person to take the money, and the municipality (which owns the parking lot) employs a person who has a counter to register how many cars have entered the parking lot. • The number of cars clicked can be reconciled with the amount of money collected to make sure both sides have the correct number. (continued)

13. Concepts Within Auditing (continued) • Electronic Data Processing (EDP) Systems • EDP allows businesses to simplify operations such as accounts payable, payroll, and inventory control. • Managers still need to ensure that data entered into an EDP system is accurate. • Computers • Computer fraud is a new concern, and new internal controls have been developed to ensure the accuracy of transactions and processes. • Many businesses now do a large portion of their business through their websites and need to be aware of external threats such as hackers and viruses that could negatively affect recorded transactions.

14. Auditing Process • Selecting an Auditor • Seek out an auditor who has experience in the industry of your business. • PricewaterhouseCoopers, Deloitte, and KPMG are firms familiar with auditing the sport industry. • For example, the pay structure for players can be complex because of signing bonuses, performance incentives, and deferred payments that are not seen in other industries; • Find an auditor who has dealt with these types of financial issues before. (continued)

15. Auditing Process (continued) • Preparing for the Audit • The auditor needs certain organizational materials: • Internally prepared documents: include operating documents such as sales invoices, purchase orders, general ledgers, payroll records, receiving forms, and other standard accounting worksheets • Externally prepared documents: include documents such as bank statements, loan documents, and vendor statements • Nonfinancial records: include articles of incorporation, minutes of organizational meetings, past internal or independent auditors’ reports, organizational charts, and job descriptions (continued)

16. Auditing Process (continued) • Preparing for the Audit • Auditor may need to see direct evidence of assets such as inventory, equipment, computers, and office furniture. • Auditor may need oral testimony from management, employees, or customers to ensure that the organizational information is accurate. (continued)

17. Auditing Process (continued) • Cash Auditing • For many sport businesses, cash is the most important current asset. • Role of the auditor is to ensure that cash assets are not overstated and that financial statements accurately represent the cash level. • In some instances, a business may have too much cash on hand; the auditor may recommend reinvesting the cash back into the business or investing in other opportunities. • Auditor may also find that the organization has relatively low cash balances, which could cause long-term problems if the business can’t meet its debt obligations. (continued)

18. Auditing Process (continued) • There are recommendations for handling cash receipts to ensure accuracy and reduce the chance of fraud: • No single employee should be responsible for handling cash transactions from beginning to end. • Cash handling should be separated from cash recording and deposit. • Cash receipts should be centralized. • Cash receipts should be deposited on a daily basis. • When possible, make all payments by check, credit card, or debit card. (continued)

19. Auditing Process (continued) • Inventory Auditing • Inventory auditing is the process of determining exactly what inventory exists and the inventory’s value. • Because inventory must be purchased, received, recorded, stored, and distributed, management is responsible for developing internal systems to efficiently perform all these operations and accurately keep track of these operations. • Auditor must also determine the fair value of the inventory; will base the value of inventory on its quantity, quality, and condition. (continued)

20. Auditing Process (continued) • Plant, Property, and Equipment Auditing • Auditor ensures that all plant, property, and equipment that are listed as assets actually exist. • Difficult task is determining a fair value for these assets. • Depreciation must be factored into the determination of fair value. • Payroll Auditing • This process tracks employee compensation to ensure accuracy; determines if employees are working too much overtime or whether personnel costs are in line with budgetary projections. • It also seeks to ensure that income tax deductions, Social Security payments, and deductions for benefits such as retirement, union dues, and health insurance are being properly paid out. (continued)

21. Auditing Process (continued) • Auditor’s Report • The report is unqualified if no information is lacking and nothing that differs from the standard accounting practices set forth by the Auditing Standards Board is found. • A standard unqualified auditor’s report has seven parts: • Report title. Auditing standards require that a report have a title that includes the word independent. • Audit report address. The report is usually addressed to the auditee, its board of directors, or stockholders. (continued)

22. Auditing Process (continued) • A standard unqualified auditor’s report has seven parts: • Introductory paragraph. This paragraph explains the management’s role and responsibilities as they apply to the auditor (i.e., that management helped provide documentation or access to facilities). It also lists all the financial statements that were audited and the time periods of those statements. • Scope paragraph.This paragraph describes the nature of the audit and what the auditor did in the audit. It also outlines the business areas examined by the auditor. • Opinion paragraph.This last paragraph states the auditor’s opinion. Within this section, the auditor attests to the accuracy of the financial information provided by the auditee. • Name of the certified public accountant’s firm. • Audit report date.

23. Responding to Financial Problems • A report is considered qualified if information is lacking or because other problems prevented the auditor from giving a more complete report. • File for Chapter 11 bankruptcy protection. • Pursue cost-cutting measures. • Example: a college’s athletic department dropping multiple sports • Change policies and procedures.

24. Questions for Class Discussion • What are the two fundamental roles of auditing? • Provide three specific examples of how the operational efficiency of an organization may be improved through the use of internal audits. • How would you go about auditing Speedway Motorsports, a high school athletic program, a fitness facility, and a Division I college athletic department? (continued)

25. Questions for Class Discussion(continued) • How can you balance the need for making sure that accounts are accurate and the need to allow people to work without the fear that someone is watching their every move? • Why is accuracy important? • What are the primary benefits to an organization of using an independent auditor? • What are the advantages of using an independent auditor versus using an internal auditor? (continued)

26. Questions for Class Discussion (continued) • Is it ethically correct to “permanently borrow” office supplies? • How would you approach someone if you thought that she had engaged in fraud? • Provide two examples of advances in technology that have changed the manner in which audits occur.