Operational Auditing

OPERATIONAL AUDITING ELLYSA GAIL S. CAMUTIN MIKE FRANCIS PEÑALOSA

NATURE •OPERATIONAL AUDIT also known as management audit and performance audit, are

conducted to evaluate the effectiveness and/or efficiency of operations. •These are examinations of all or part of an entity to determine the degree of its

operational efficiency, effectiveness, and economy. •It also refers to the auditor’s study of business operations for the purpose of making

recommendations about economic and efficient use of resource, effective achievement of business objectives and compliance with company policies. •OPERATIONAL implies a focus on operations, as opposed to financial position. •MANAGEMENT implies that the information obtained in the audit process is useful to

management in decision making. •PERFORMANCE implies an evaluation of the performance of persons or units in

executing the entity’s objectives. •NOTE: WE USE THE TERM OPERATIONAL AUDITING BECAUSE IT IS MOST

WIDELY USED TODAY.

EFFECTIVENESS VS. EFFFICIENCY; ECONOMY • EFFECTIVENESS refers to an entity’s or a unit of an entity’s success in

actually achieving its goals and objectives. • EFFICIENCY refers to how well an entity uses its resources to achieve its

goals. It is also described as reducing cost without reducing effectiveness. • • • • • •

TYPES OF INEFFICIENCY: Work is done that serves no purpose. Raw materials are not available for production when needed. Acquisition of goods and services is excessively costly. There are too many employees. There is duplication of effort by employees.

• ECONOMY refers to an entity’s success in maximizing the use of its

limited resources to achieve its goals and objectives.

OBJECTIVE OF OPERATIONAL AUDIT Operational Audit is often performed by INTERNAL AUDITORS for their organization. Major users of operational audit reports: MANAGERS AND BOARD OF DIRECTORS Top management needs assurances that every component of an organization is working to attain the organization’s goals. For example, management needs the following: 1. Assessment of the unit’s performance in relation to management’s objectives or other appropriate criteria 2. Assurance that its plans are comprehensive, consistent, and understood at the operating levels. 3. Objective information on how well its plans and policies are being carried out in all areas of operations and on opportunities for improvement in effectiveness, efficiency and economy. 4. Information on weaknesses in operating controls, particularly as to possible sources of waste. 5. Reassurance that all operating reports can be relied on as a basis for action.

• GOVERNMENTAL AUDITORS, such as those employed

by the Commission on Audit (COA), perform operational audits of governmental programs that are administered by both governmental and nongovernmental organizations.

SCOPE OF OPERATIONAL AUDIT The broad statement of purpose of an operational audit usually includes the intention to appraise the performance of a particular organization, function, or group of activities. The operational auditor appraises management’s operating controls and systems over such varied activities as purchasing, data processing, receiving, shipping, office services’, advertising, engineering etc. 1.

ECONOMY AND EFFICIENCY AUDITS which include determining (a) whether the entity is acquiring, protecting, and using its resources (such as personnel, property, and space) economically and efficiently, (b) the causes of inefficiencies or uneconomical practices, and (C) whether the entity has complied with laws and regulations concerning matters of economy and efficiency.

2.

PROGRAM AUDITS include determining (A) the extent to which the desired results or benefits established by the legislature or other authorizing body are being achieved, (B) the effectiveness of organizations, programs, activities, or functions and (C) whether the agency has complied with laws and regulations applicable to the program.

3.

COMPLIANCE AUDIT includes testing and reporting on whether an organization has complied with the requirements of various laws, regulations and agreements.

DISTINCTION BETWEEN OPERATIONAL AUDITING (OA) AND FINANCIAL AUDITING (FA) OPERATIONAL Auditing (OA) A. Purpose of the Audit • Emphasizes effectiveness, efficiency, and

economy. • Concerned with operating performance for the future. B. Nature and Distribution of the Report • Reports are intended primarily for

management. • OA reports vary considerably from audit to audit of the diverse nature of audits for efficiency and effectiveness. C. Inclusion of Non-financial Areas • OA’s covers any aspect of efficiency and

effectiveness in an organization and can therefore involve a wide variety of activities

Financial Auditing (FA) A. Purpose of the Audit • Emphasizes whether historical information was correctly recorded. • Past-oriented.

Nature and Distribution of the Report • Report typically goes to many users of financial statement (stockholders and bankers) • Wording in FA reports is well-defined because of the widespread distribution of the report. B.

C. Inclusion of Non-financial Areas • FA’s are limited to matters that directly affect the fairness of financial statement presentation

TYPES OF OPERATIONAL AUDITS There are three broad categories of operational audits: 1. FUNCTIONAL 2. ORGANIZATIONAL 3. SPECIAL ASSIGNMENTS In each case, part of the audit is likely to concern evaluating internal controls for efficiency and effectiveness.

FUNCTIONAL A functional audit deals with one or more functions in an organization. Functions are a means of categorizing the activities of a business, such as the billing function or production function. There are many different ways to categorize and subdivide functions. A functional audit has the advantage of permitting specialization by auditors. A disadvantage of functional auditing is the failure to evaluate interrelated functions.

ORGANIZATIONAL An Operational Audit of an organization deals with an entire organizational unit, such as department, branch, or subsidiary.

The emphasis in an organizational audit is on how efficiently and effectively function interact. The plan of organization and the methods to coordinate activities are especially important in this type of audit.

SPECIAL ASSIGNMENTS Special operational auditing assignments arise at the request of management. There are a wide variety of such audits.

Examples: 1. Determining the cause of an ineffective EDP system. 2. Investigating the possibility of fraud in a division 3. Making recommendations for reducing the cost of a manufactured product.

WHO PERFORMS OPERATIONAL AUDIT? INTERNAL AUDITORS are in such a unique position to perform operational audits that some people use internal auditing and operational auditing interchangeably. An advantage that internal auditors have in doing operational audits is that they spend all their time working for the company they are auditing. They develop considerable knowledge about the company and its business, which is essential to effective operational auditing. To maximize their effectiveness, the internal audit department should report to the board of directors or p resident. Internal auditors should also have access to and on-going communications with the audit committee of the board of directors. This organizational structure helps internal auditors remain independent.

GOVERNMENT AUDITOR Most of the government auditors are concerned with both financial and operational audits, also referred to as performance audits. Performance audit include the following: 1. ECONOMY AND EFFICIENCY AUDITS. These have as their purpose determining (1) whether an entity is acquiring, protecting, and using its resources economically and efficiently, (2) the causes of inefficiencies or uneconomical practices, and (3) whether the entity has complied with laws and regulations concerning matters of economy and efficiency. 2.

PROGRAM AUDITS. These have as their purpose determining (1) the extent to which the desired results or benefits established by the legislature or other authorizing body are being achieved, (2) the effectiveness of organizations, programs, activities, or functions and (3) whether the entity has complied with laws and regulations applicable to the program.

The first two objectives of each of these types of performance audits are clearly operational in nature. The final objective in each is compliance in nature.

CPA FIRMS The background knowledge about a client’s business that an external auditor must obtain in doing an audit often provides useful information for giving operational recommendations. It is also common for a client to engage a CPA firm to do operational auditing for one or more specific parts of its business.

IMPORTANT QUALIFICATIONS OF OPERATIONAL AUDITORS 1. To whom the auditor reports to. It is important to ensure

that investigation and recommendations are made without bias. 2. Independence. It is not a problem for CPA firm auditors because they are not employed by the company being audited. Internal auditors can enhance their independence by having the internal audit department report to the BOD or president. But the responsibilities of operational auditors can affect their independence. 3. Competence. It is necessary to determine the cause of operational problems and to make appropriate recommendations. Competence is a major problem when operational auditing deals with wide-ranging operating problems.

CRITERIA FOR EVALUATING EFFECTIVENESS AND EFFICIENCY A major difficulty found in operational auditing is in deciding on specific criteria for evaluating whether efficiency and effectiveness have occurred. PFRS are the broad criteria for evaluating fair presentation in auditing historical financial statements. Audit objectives are used to set more specific criteria in deciding whether PFRS have been followed. In operational auditing, no such well-defined criteria exist. Different approaches can be used to evaluate efficiency and/or effecitveness. 1. Look at an entity’s overall level of profitability. 2. For profit entities, you can check the improvement in the defect rate. Identifying criteria for evaluating effectiveness and efficiency may be very difficult in the absence of specific standards.

There are several sources that the operational auditor can utilize in developing specific evaluation criteria. These include the following: 1. Historical Performance 2. Comparable Performance 3. Engineered Standards

4. Discussion and agreement