Part 1

List the various sources of audit criteria.

The sources of audit criteria include:
 laws and regulations governing the organization
 organizational policies, directives, and procedures manuals
 professional associations
 publications of standard-setting bodies
 authoritative literature
 benchmarking studies
 earlier internal audits
 common sense and experience

Part 2
For each of the following independent audit findings, identify the relevant source of audit
criteria from the sources in part 1, and briefly describe the specific criteria relevant to the
situation described. (Remember to focus on the source of the criteria, not on evidence to
determine whether operations are in compliance with the criteria)
Note: These audit findings are either deficiencies that need to be corrected or conditions that
may be acceptable but could be improved.
1. The auditors reviewed the company’s dental plan. They found 12 employees who were
no longer with the company listed as active and covered by the plan.
a. organizational policies, directives, and procedures manuals
b. earlier internal audits
c. common sense and experience
2. During an audit of the company’s purchasing/payments system, the auditors found that
a significant number of purchase orders were being issued and processed for small
dollar amounts.
a. organizational policies, directives, and procedures manuals
b. earlier internal audits
c. common sense and experience
3. An audit of the company’s waste disposal practices revealed 10 instances where the
company had not complied with the regional district by-laws on safe disposal of
industrial waste.
a. laws and regulations governing the organization
b. organizational policies, directives, and procedures manuals
c. professional associations
d. publications of standard-setting bodies
4. The auditors found that the amortization methods used by one of three major divisions
of the company were being changed every few months in an attempt by management to
match their budget goals for the quarter.
a. laws and regulations governing the organization
b. organizational policies, directives, and procedures manuals
c. professional associations
d. publications of standard-setting bodies
 e. authoritative literature
f. earlier internal audits
5. During an audit of the company’s maintenance procedures, the auditors found that
major servicing of the manufacturing equipment was being carried out annually.
However, the company maintenance manual for the machinery indicates that
maintenance must be carried out semi-annually.
a. laws and regulations governing the organization
b. organizational policies, directives, and procedures manuals
c. publications of standard-setting bodies
d. authoritative literature
e. benchmarking studies
f. common sense and experience
6. In planning the audit of the company’s sales department, the auditor interviewed
management and found that the philosophy of the sales department is to give the best
customer service in the industry. However, a sample of customers who were contacted
had consistent complaints about the after-sales contacts and follow-up by the sales staff
in the western region.
a. organizational policies, directives, and procedures manuals
b. benchmarking studies
c. earlier internal audits

7. One of the steps in planning an internal audit engagement involves developing staffing
plans and time budgets. Briefly outline the main considerations in determining the
specific audit staff to be assigned to an internal audit engagement.

Both managers and the individual internal auditor have a responsibility to evaluate the
performance of staff performing internal audits on both a continuing and periodic basis. Briefly
outline the matters that should be considered in such evaluations.

The lesson provides information on how the internal auditor prepares long-term and short-
term audit plans. To be practical and useful, all plans must be flexible. There are a variety of
reasons why the internal auditor would revise the annual plan after it has been approved.
Required

Why might an annual internal audit plan be revised after it has been approved?
Solution
6. CASE STUDY T4-1: Venus Ltd.
Venus Ltd. (VL), one of the largest manufacturers of chocolate bars in North America, is a public
company incorporated under the Canada Business Corporations Act. Its head office is in
Montreal, and its shares are traded on the Toronto Stock Exchange.
VL operates four manufacturing facilities in Canada, located in Halifax, Laval, Toronto, and
Vancouver. The corporation has 1,100 employees and a payroll of $31.5 million. The company
makes 25 kinds of chocolate bars for the Canadian and American markets. Each plant
manufactures different products. In the chocolate bar market, the retail price structure is
extremely rigid, and consequently, cost and inventory control are crucial factors to VL’s success.
All VL’s accounting and management systems are computerized. The central computer is
located at head office, and each plant is linked by online access to the system. Terminals and
printers are located in the head office and in the offices and warehouses of branch plants. Users
of the system at head office and in the plants are responsible for data entry and for exercising
appropriate control over all data processing operations. The data processing department at
head office is responsible for the management and control of computer installations and
systems modifications and for resolving any problems that may arise.
Sales and marketing. All sales and marketing activities are centralized at head office in
Montreal. The sales department at head office receives orders from clients and enters them in
the computerized order processing system. Shipping vouchers are printed directly at the plants
from which the merchandise will be shipped. From shipping data keyed in by warehouse
personnel, the computer system at head office generates customer invoices and updates the
various accounting records.
The marketing department at head office is responsible for market analysis, product
management, sales forecast preparation, promotion and advertising, as well as customer
relations. Marketing and advertising strategies are established by the staff of the marketing
department in cooperation with advertising agencies.
In spite of a significant increase in advertising expenditures in 2010, sales declined. During the
same period, total sales of chocolate bars in the Canadian and American markets rose by 10%
and 12%, respectively. The advertising budget for 2011 has been set at $28 million.
Research and development. New product development is the responsibility of the research and
development department at head office. Market testing of new products is carried out in
selected regions of Canada and the United States in cooperation with the marketing
department. The company has launched three new products during the last two years, but sales
of these new products have been far below forecasts.
Purchasing and inventory. Chocolate and sugar are the two basic ingredients in the
manufacturing of chocolate bars. Chocolate is made from cocoa beans. Contracts for
purchasing cocoa beans are negotiated with the South American producers by the purchasing
department at head office. Because prices of this commodity are highly volatile, VL tries to fix in
advance the contract price for each delivery date. Head office arranges deliveries to be made
directly to the plants according to approved production schedules. The beans are then stored in
silos at the plants.
Each plant buys the sugar it requires from local suppliers. The sugar is stored in warehouses
located next to the cocoa bean silos and is drawn from storage on a first-in, first-out basis,
ensuring that the oldest sugar is used first. Each plant keeps perpetual inventory records of the
quantity of these two important food commodities. VL has no systematic stocktaking procedure

but corrects inventory records as required when reaching the bottom of a silo or the end of a
pile of sugar. At the end of each quarter, the value of inventory is determined using the lower-
of-cost or replacement-value method.
Production. After semi-processed chocolate is produced from cocoa beans, the most important
step in the manufacturing process consists of adding various flavouring ingredients to the
semi-processed chocolate and refrigerating the end-product. Twenty-four hours later, the
product is cut and wrapped, placed in 24-unit display boxes, and sent to the warehouse for
storage and shipping. If the chocolate bars remain in storage longer than three months, they
are unwrapped and shipped to various surplus stores to be sold in blocks at discount prices.
According to VL’s procedures, if the net realizable value is lower than cost, inventory is valued
at the lower amount. Internal audit. Tony Gianelli, CGA, has just been appointed chief audit
executive for VL. This department has three experienced internal audit teams to carry out
audits at head office and in the plants.
Problem areas. This morning, the president of VL has mentioned to Tony that VL faces certain
operational problems. The following are of particular interest to the president:
The company faced an inventory shortage last February and March for two products
manufactured in the Toronto and Vancouver plants. This situation created some dissatisfaction
among VL’s customers and was all the more embarrassing since the company had launched a
$3.5 million advertising campaign in the fall of 2011 to spur public interest in these products,
which had first been introduced in 2005.
The company suffered significant losses because of production surpluses in the Toronto,
Halifax, and Laval plants during the last few months. Since some products had been in storage
for over three months, they had to be sold in blocks at discount prices.
It seems that VL’s competitors are getting their cocoa beans and sugar purchases at better
prices. The president told Tony that the director of purchasing had heard that some
competitors were bribing South American political leaders to get better prices from the state-
controlled companies producing cocoa beans in these countries. The president believes that
this situation could have serious repercussions on the competitive position of VL and that it is
absolutely essential that VL get the best possible prices.
According to some rumours circulating in the purchasing department, one of the buyers has a
lifestyle far above what his salary could support. This buyer is responsible for the management
of several large procurement contracts. The director of purchasing has been unable to supply
greater detail on this matter but finds the situation rather odd.
The Vancouver and Laval plants appear to have more and more difficulty controlling production
costs. In the last few months, significant variances from standard costs have appeared in the
use of raw materials and in labour productivity.
The significant increase in advertising expenditures during 2011 and the beginning of 2012 does
not appear to be yielding the results anticipated. Sales for 2011 have decreased and VL’s
market share has dropped by more than 10%. The marketing department appears to have
difficulty estimating the effectiveness of its marketing and advertising strategies.
The president told Tony that the internal audit department did not have any formal audit plans
and that the preparation of such plans should be one of his priorities. The president would like
to table a long- term five-year audit plan at the next audit committee meeting, scheduled in
two months. Tony asked the audit manager, Janet McMahon, CPA, to assist in the preparation
of the long-term audit plan. As a starting point, Tony requires a report outlining the following
areas:
specific project areas to be reviewed that are most critical for the organization, together with
the rationale for selection (What would you look at specifically in each of these audit areas?)
other specific activities of medium or low audit priority that should be undertaken over the next
five years
Required
Assume the role of Janet McMahon and prepare the report as requested by Tony Gianelli.

CASE STUDY T4-2: Funky Clothes Ltd.

Having qualified as a CGA three years ago and working in the internal audit department of a
large university, you gained valuable experience in proper internal audit techniques and current
practices. You did not expect any advancement opportunities in the department for several
years, and therefore accepted a challenging position as internal auditor in a small but growing
retail clothing business, Funky Clothes Ltd. You report directly to the owner/president and
believe you qualify for the financial vice-president position if you can demonstrate a high level
of competence as internal auditor.

After a three-month orientation period, the president has asked you how you would approach
the development of a long-term audit plan for the organization. Prior to your employment with
the company, the president, in consultation with some of the senior staff, had put together a
preliminary list of potential audit areas:

Potential audit areas

cash and banking

travel expenses
purchasing
payroll
inventory
staff social committee
petty cash
computer security
corporate reporting
accounts payable.
treasury
company logo design
annual financial statements
budgeting
The president has asked you to prepare a preliminary long-term plan, using some rational
method, showing which areas are most important for audit.

During your orientation period, you have learned the following about the company:

Funky Clothes Ltd. was formed 10 years ago and has grown rapidly from one store to 20 stores,
plus a head office, in a growing international city. Sales last fiscal year (cash and credit card)
were $75 million: gross profit $60 million and net profit $16 million. The total number of
employees for all stores is 512. Each store has a manager, sales staff, and one assistant
manager/accountant who is responsible for entering all financial and accounting data into a PC
- based accounting system, used in all stores. All weekly totals are e-mailed to head office,
where a small accounting staff load the data and prepare quarterly financial statement s for
management information and control.

The vice-president of finance and other senior managers seem generally satisfied with the
quarterly statements, but there have been large errors in some of the statements. You saw a
memo written last year to the computing staff, asking for monthly instead of quarterly
statements, with the response that this could not be done due to the carry-forward of monthly
figures. There was no additional correspondence.

You note that the emphasis on computing has been to streamline operations, and such issues
as backup, use of passwords, and confidentiality of company data have not been addressed to
date.

The accounting staff report to the vice-president of finance, who is retiring in two years. The
company is privately owned, with all shares owned by the president and her family. The
company has an annual external audit of its financial statements, primarily to meet the loan
conditions of the bank, the major creditor. The company is in strong financial condition, with
profits improving each year, and a low debt-to-equity ratio.

Each store deposits into its own local bank account, and the assistant manager does all banking
except payroll at the store. This includes deposits, making payments to suppliers, reconciling
the account, and clearing all excess cash to the head office account monthly. Store cheques
require one signature, and all banking records are kept at each store.

Payroll is done at head office, mainly for efficiency. It is done by a payroll clerk, using a popular
payroll package, under the supervision of the accountant. You have discussed the payroll in
detail with the accountant, and controls appear to be strong. The process appears to be
efficient, and staff members have no complaints.

Each store keeps a large quantity of all the company’s offerings to avoid stock-outs and keep
customers happy. Some of the managers have had to rent additional warehouse space, which is
becoming very expensive, especially in the shopping mall locations. Head office has noticed
some problems with obsolescence developing last year.
After extensive discussions and input from all store managers and head office staff, the vice-
president of finance prepares an annual sales budget, an operating budget, a capital budget,
and a cash flow statement. The budget process starts with careful sales projections and works
from there. The president approves all budgets at the beginning of each year, and each store
then gets a monthly budget to monitor sales and control costs. An accounts clerk at head office
prepares monthly actual-to-budget reports, and highlights significant variances for the
accountant and other management attention.

The president travels extensively, visiting trade shows and potential sources of merchandise.
She flies first class on all air travel, rents luxury cars, and stays in five-star hotels. Major receipts
are attached to the travel vouchers, but there are no approvals. Travel for all other staff is
insignificant.

From discussions with suppliers, you noted that they are very complimentary about your
company’s accounting system: the invoices seem to get paid much faster by your company than
other companies, sometimes even before the invoice is sent out. You asked the accountant
about this, who indicated that this is probably due to each store making its own payments.
Required

a. Which of the 14 audit areas supplied by the president should be subject to an internal
audit? Provide reasons for each area you identify.
a. cash and banking - Yes
b. travel expenses – No private company
c. purchasing – Yes, rumours in dept
d. payroll – Yes, risk for fraud
e. inventory - Yes
f. staff social committee – No
g. petty cash – Yes, risk for fraud
h. computer security – Yes, important controls
i. corporate reporting - Yes
j. accounts payable - Yes
k. treasury - yes
l. company logo design - No
m. annual financial statements - No
n. budgeting - Yes