INDEPENDENCE 11. 12. 13. Audit committees should satisfy themselves by appropriate inquiry that auditors are independent in fact and in appearance (page 38). All significant professional services provided by the auditor should be reviewed by the audit committee at least annually (page 44). In connection with appointment or reappointment of auditors, 14. BUSINESS ETHICS Business organizations should adopt, and make public, codes of conduct which apply from the chief executive officer down (page 138). THE AUDITOR: HIS FUNCTION AND HIS REPORT Many of the deficiencies in the Staff Study flow from an apparent failure to understand the objectives and the limitations of an audit. Following is a description, in non-technical terms, of this function. WHAT AN AUDIT IS An audit is the performance of a planned set of procedures by which the auditor (1) reviews a client's internal procedures designed to safeguard its assets and properly record its transactions, (2) examines, on a test basis, supporting documents, and (3) obtains independent outside confirmation of certain transactions--all for the purpose of forming an opinion as to the fairness of presentation of the information in the client's financial statements in conformity with generally accepted accounting principles. As with any large undertaking, planning is necessary before actually starting the on-site work. Planning for an audit includes decisions such as assigning the right professional people to the right job, determining the timing of procedures, and selecting the client locations to be visited. Once this planning has been completed, the actual audit procedures may be undertaken. In a large company, there are many individual sets of records, such as those for subsidiaries, divisions, and branches. Often there are records maintained overseas in different currencies. The thousands or millions of individual transactions--purchases of goods, payments of payrolls, rentals of equipment, sales of products--are recorded, classified, and summarized into three "basic financial statements." Planning an audit of these statements requires an understanding of the organization of the company and the procedures it uses to record these numerous transactions and to prepare its financial statements. It would be too expensive for auditors to examine or verify every transaction. Accordingly, auditors use a twopronged approach: (1) review the procedures the company follows and (2) make tests of transactions and balances. Initially, then, the audit involves a review of the company's internal accounting controls--that is, those internal procedures established by the company to ensure that its transactions are properly recorded in its books of account and that its assets are properly protected. For example, by establishing an internal control procedure which assigns to separate employees (1) the physical handling of incoming cash receipts for sales, (2) the recording of cash receipts, and (3) the reconciling of bank statements, a company makes it virtually certain, unless there is collusion, that if one person removes cash receipts from the company, another person in performing his or her tasks will detect the removal. In addition to these controls, an audit includes sampling or testing the flow of documents through the system. Generally, by using statistical methods, auditors assure themselves that the sample of transactions examined is representative of all the transactions which the company processes. Our judgment as to the effectiveness of a company's internal controls determine, in part, what other auditing procedures will be performed. Obviously, when controls are well designed and are functioning properly, the risks that assets have been misappropriated or that transactions have been improperly recorded are substantially less than if controls were poorly designed or functioned poorly. Our audit procedures take this into consideration. Other Audit Procedures Following are examples of our other procedures: We generally confirm bank balances by corresponding with the banks, reconcile bank accounts, confirm accounts receivable by corresponding with debtors, and follow up exceptions. We review the aging and collection patterns of accounts receivable and perform other tests to determine the reasonableness of the allowance for bad debts. We observe the company's counting of its inventories and do some counting ourselves. We test the company's summarization and pricing of its inventories and consider whether the company can dispose of its inventory in the ordinary course of business. Should a company face problems in disposing of its inventory, it may be necessary to write down the carrying value to an estimated amount to be realized on sale. Our audit procedures also include tests of the costs of inventory, as well as the expected ultimate realizable value, so that we can determine that the inventory is appropriately valued at the "lower of cost or market." With respect to additions to fixed assets or marketable securities or other assets of the company, we examine, on a test basis, original documents, such as cancelled checks, invoices, and receiving reports in order to assure ourselves that transactions have been properly recorded. We count marketable securities or confirm their existence and ownership with independent depositories and we check the value of the securities to current market quotations. We check the calculation of depreciation of fixed assets to ensure that the cost is being allocated on a reasonable basis over the estimated lives of the assets. With respect to liabilities, we review disbursements made and invoices received after the balance sheet date and refer to receiving records in order to assure ourselves that liabilities incurred at that date were recorded. We confirm indebtedness directly with banks and other lending institutions. We review the company's income tax accruals to satisfy ourselves that they are reasonably stated with respect to income earned during the period and prior periods. Our audit also checks the "cut-off" of sales at year-end by reference to shipping records to assure ourselves that only items which have been shipped during the year have been recorded in the year's sales accounts. We review the company's accounting, grouping of accounts, and financial statement presentation to satisfy ourselves that treatments are consistent within the year and with prior years. We are Many of the above procedures are done on a "test" basis. also alert during the course of our audit for unusual transactions which could materially affect the company's financial statements. When we become aware of such transactions, we investigate them until we are satisfied that they have been accounted for and disclosed in conformity with generally accepted accounting principles. During the course of an audit, we meet frequently with senior management to gain an understanding of the various transactions in which the company has been a participant so that we can assure ourselves that the economic substance of these transactions has been reflected in the financial statements. In many cases, we meet with a company's board of directors and audit committee to discuss matters of importance and to report upon the progress of our examination and our findings. |