CHAPTER 2

THEORITICAL FOUNDATION

2.1

Auditing

2.1.1

Definition of Auditing
The term auditing was derived from the word audire, which means to hear.
(Gill et al. 1999, p. 4). Moreover, according to Arens et al. (2006, p. 4), auditing
can be defined as:
The accumulation and evaluation of evidence about information to determine
and report on the degree of correspondence between the information and
established criteria.

Moreover, as stated in the Auditing and Assurance Services in Australia book by

Gay & Simnett (2007, p. 16), the definition of auditing according to American
Accounting Association (AAA) in A Statement of Basic Auditing Concept
(ASOBAC) is:
A systematic process of objectively obtaining and evaluating evidence
regarding assertions about economic actions and events to ascertain the degree
of correspondence between those assertions and established criteria and
communicating the results to interested users.

Therefore, auditing could be defined as the process to analyze certain objects and
collect the evidences to check whether there is degree of correspondence
between the objects and the established criteria. Besides, an audit should be
conducted by person who is competent and has adequate knowledge of auditing.

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2.1.2

Types of Audits
As discussed by Arens et al.(2006, p.14), generally, there are three types of
audits:

Financial Statement Audit

The financial statement audit is performed to determine whether the
companys financial statements are created based on the valid accounting
standards. Moreover, according to Gill & Cosserat (1996, p. 4), the financial
statements audit is usually conducted by the external auditors who is
selected by the shareholders of the company. Furthermore, after performed
the audit, the auditor should report the findings to several parties including
the shareholders, creditors, regulatory agencies, and public.

Compliance Audit
The compliance audit is performed by the auditor to evaluate whether
specific financial or operating activities of the company are suitable with
certain conditions, rules or regulations set by the specific authorized party.
For example, some companies establish the internal audit function which
responsible to perform the compliance audit based on criteria set by the
management. In addition, the auditor should report the findings of
compliance audit to the authority that create the criteria.

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Operational Audit
According to Arens et al. (2006, p. 14), the operational audit is performed to
evaluate the effectiveness and efficiency of the operating procedures,
methods and activity in the company. Generally, the scope of operational
audit includes all activities of a department, branch or division. In addition,
the scope might also include the activities of a function that cross the
business unit lines such as data processing function.

In addition, based on Gay & Simnett (2007, p. 38-39), the auditor might also
perform the comprehensive audit, which is the integration of financial statement
audit, compliance audit, and the performance audits. Moreover, due to the
increasing use of technology in business, the auditor is required to perform the
information system audit. The objective of this type of audit is to evaluate the
companys internal control especially which related with the information
processing using the computer systems.

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2.2

Operational Audit

2.2.1

Definition of Operational Audit

According to Gay & Simnett (2007, p. 716), the term operational audit is also
referred as the value-for-money (VFM), performance audit or management audit.
The operational audit is performed to evaluate the effectiveness and efficiency of
the entitys operating activities.

Furthermore, as stated in Auditing and Assurance Services in Australia (Gay &

Simnett 2007, p. 716), the term efficiency and effectiveness are defined in AUS
806 as follow:

Based on AUS 806.04, the term efficiency is defined as the use of a given
set of resource inputs to maximize the outputs.

Based on AUS 806.05, the term effectiveness is defined as the achievement

of the objectives or other intended effects of activities.

In addition, another definition of effectiveness and efficiency, based on

BusinessDictionary.com is:

Effectiveness is defined as the degree to which objectives are achieved and

the extent to which targeted problems are resolved. In other word,
effectiveness

might

be

defined

as

doing

the

right

thing.

(BusinessDictionary.com, WebFinance, Inc. 2008)

Efficiency is defined as comparison of what is actually produced or

performed with what can be achieved with the same consumption of
resources (money, time, labor, etc.). In other word, efficiency might be
defined as doing the thing right.
(BusinessDictionary.com, WebFinance, Inc. 2008)

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Besides, according to Gay & Simnett (2007, p. 716), the operational audit might
also include the review of:

Use of human, financial, and other resources;

Information systems, performance measures and monitoring arrangements;

Procedures followed by audited bodies for remedying identified

deficiencies.

Furthermore, after perform the operational audit, the auditor usually create the
audit report regarding the findings and provide some recommendations for the
improvement of the units that had been evaluated.

2.2.2

Types of Operational Audit

According to Arens et al. (2006, p. 778), there are three types of operational
audit that are:
1. Functional Audit
The functional audit is performed to evaluate the effectiveness and
efficiencies of one function or more in an organization. For example, the
auditor perform the functional audit of procurement or purchasing division to
evaluate whether the purchasing staff had made right decision to buy the
goods which have good quality with lowest prices.

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2. Organizational Audit
The organizational audit is performed to evaluate the effectiveness and
efficiency of the organizations procedures or methods that are used by all
organizational units in the organization including the divisions, subsidiaries
or branches. Moreover, this type of audit is also including the evaluation
regarding the effectiveness and efficiency of interaction among the divisions.

3. Special Assignment
The special assignment is usually performed by the auditor based on the
demand of management. The management might ask the auditors to evaluate
certain aspect of the company which is vulnerable to fraud or the
ineffectiveness and inefficiency of the existing procedures.

2.2.3

Stages Performed in Operational Audit

According to Gay & Simnett (2007, p. 719), there are several stages that should
be performed by the auditor in conducting the operational audit. Those stages
are:
1. Planning Stage
In the planning stage, the auditor should perform observation about the
clients company in order to collect the information needed and identify the
specific area that need to be audited. In addition, the auditor should also
obtain good understanding about the business of clients company and the
industry where the business operated.

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2. Preliminary Study Stage
In this stage, the auditor should determine the main issues of the audit, the
scope of audit and the schedule of audit work. Moreover, in this stage, the
auditor should also collect the information regarding how the operating
activity supposed to run and how the control activities supposed to work.
(Gay & Simnett, 2007, p. 720).

Nevertheless, the auditor should perform the analysis about the control
environment and the control activities implemented in the company. The
aspects that should be analyzed for those controls are:
i. Control environment
The control environment indicate the actions, policies, and procedures
performed by the top level of management, board of directors, owner and
managers regarding the importance and implementation of internal
control in the company.

ii. Control Activities

The control activities are defined by Arens et al. (2006, p. 278) as the
policy and procedures implemented in the company that consists of:
1. Adequate separation of duties;
2. Proper authorization of transactions and activities;
3. Adequate documents and records;
4. Physical control over assets and records;
5. Independent checks on performance.

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Furthermore, there are several procedures that could be used to obtain
information in the preliminary study stage, including:

Interviewing (Inquiry)
The auditor could perform interview with responsible staffs to obtain
information in specific area of clients company. Moreover, it will be
better if the auditor use open-ended and uncritical question approach
hence it do not waste the time of both parties and the clear picture of
the companys condition can be obtained well.

Observation
The auditor could perform physical observation regarding how the
staffs perform daily business operating activities in the company.
Hence, the auditor can evaluate whether the staffs had performed their
duties according to applicable standards or not. Moreover, as discussed
by Gay & Simnett (2007, p. 721), the auditor might perform walkthrough of transactions technique.

In performing this technique the auditor review the re-performance of

some transactions related to daily business operations from the
beginning step to the end. The purpose is to collect the information
regarding how the clients company performs the operating activities,
the ability of staffs, and the weaknesses that occur in the companys
existing procedures.

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3. Implementation Stage
As stated by Gay & Simnett (2007, p. 721), in the implementation stage the
auditor should perform several actions including:

Create the audit programs that relate the audit objectives to audit
procedures
In creating the audit programs, the auditor must determine the scope of
audit and state the clear audit objectives of every audit tests that will be
performed. Hence, the auditor can collect sufficient appropriate
relevant evidences that could support the auditor in making the audit
opinion.

Collect sufficient appropriate audit evidences by performing the

audit tests needed
When the auditor want to evaluate the effectiveness of internal control
implemented in the companys operating procedures, the type of audit
test that should be performed is the tests of controls. Moreover, there
are some procedures of tests of controls that should be performed in
collecting the evidences. Those procedures are obtain the information
from clients staffs regarding the business operation by using internal
control questionnaire, observe the clients staffs when performing the
business operation procedures and examine the documents related with
the clients business operating activities.

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Forms the audit findings, conclusions and recommendations.

After performing the audit test needed, the auditor should analyze the
audit findings, reach the conclusions and create recommendations
needed to improve the current performance of the unit being audited.

4. Reporting Stage
After performed all audit programs stated in operational audit procedures, the
auditor must create the operational audit report. The report consists of the
objectives,

scope

and

approach

of

the

audit,

the

findings

and

recommendations provided. (Gay & Simnett, 2007, p. 723).

2.3

Sales and Collection Cycle

2.3.1

Definition of Sales
Sales are defined as the delivery of goods and services to the customers who
have ordered it and collect some amount of money as the exchange of those
goods and services. In addition, the basic principle of sales is it can only be
recognized when the transaction is already realized, or can be quite easily
realized. In addition, the delivery of the goods or services should have taken
place for the sales recognition. (InvestorWords.com, 2008).

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However, according to Arens et al. (2006, p. 411), the definition of sales is not
only limited to the transfer of goods or services physically to the customers, but
it also include the transfer of ownership of those goods or services. Therefore,
sales might be defined as the ownership transfer of goods or services to the
customers who order it and then, the customers will pay some amount of money
as the exchange for the goods or services.

2.3.2

Sales Cycle
Based on Arens et al. (2006, p. 411), the sales cycle consist of several processes
which intent to deliver the goods and services including its ownership to the
customers. Those processes are:
1. Accept and process the customers orders;
2. Granting credit;
3. Shipping Goods;
4. Billing Customers;
5. Recording Sales.

Moreover, the further explanation of every process in sales cycle based on Arens
et al. (2006, p. 411) will be described as follows:
1. Accept and process the customers orders
The customer order could be defined as the request of customer to buy some
goods or services. The supplier who sell the goods or render the services
might accept the customer order in the written form or verbally through the
telephone.

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In addition, the supplier might also send the sales representatives to offer the
goods or services to the people and if the customers are willing to buy the
products or render the services, they could order it through the sales
representatives directly.

Furthermore, as stated by Gill & Cosserat (1996, p. 499), after received the
customer orders, the supplier will identify whether the customer who place
the order is listed in the existing approved customer list or not. If the
customer is already listed, the order will be proceed and the sales order will
be created. However, if the customer is not listed yet, the supervisor of sales
orders division should analyze the order and decided whether to accept or
reject the order.

After that, if the order from customer is accepted, the sales order will be
issued. According to Gill & Cosserat (1996, p. 499), the document serve the
function as the indicator for the start of transactions trail and it can also be
used as the evidence for the management. In addition, the document consists
of the description of the goods or services ordered, the quantity requested and
other information related to the goods or services. (Arens et al., 2006, p.
412).

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2. Granting Credit
Generally, the credit departments in most companies who provide credit sales
to the customers should check the credit limit of the customers before they
approve the new credit sales. As discussed by Gill & Cosserat (1996, p. 499),
the credit limit checking is performed by compare the total price of new order
with the existing authorized credit limit and the existing debt of the customer.

In addition, at the present day, when the technology grown fast, many
companies implement the computer program that could automatically
approve the credit sales or reject it. The computer program will approve the
new credit sales if the total price of new order plus the existing customers
debt is less than the authorized credit limit set by the company in the
computer master file. (Arens et al. 2006, p. 412)

3. Shipping goods
The next step that will be performed after the new credit order approved by
the company is preparing the goods ordered that will be delivered to
customers. However, the staff who will deliver the goods should show the
picking list and copy of sales order to the warehouse staffs as the proof to
take the goods.

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Moreover, the warehouse staff should prepare the packing list of the goods
being delivered that indicate the description of goods, quantity, freight
charges and other relevant information. However, if the sellers use the
forwarder or carrier service to deliver the goods for customers, they should
also prepare the bill of ladings. In addition the warehouse staff should also
create the shipping notice document that consist of the document indicate that
the goods have been delivered and the copy of sales order.

4. Billing the customers

After deliver the goods or inventory to the customers, the company will
generate sales invoices related to the goods and send it to bill the customers.
Moreover, as stated by Arens et al. (2006, p. 412), the main concern
regarding billing the customers is to ensure that all the goods shipped have
been billed at authorized prices and there is no duplicate billings sent to the
customers.

5. Recording Sales
The last step perform in sales cycle is recording the sales transactions. As
discussed by Gill & Cosserat (1996, p. 500), the recording transactions could
be performed either manually or using computer system. For the manual
recording system, the process is started by inputting the sales invoices to the
sales journal. After that, the invoices are posted to the accounts receivable
subsidiary ledger and the sales journal will be posted to the general ledger
accounts.

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On the other hand, if the recording of sales transactions is performed using
the computerized system, the staff does not need to input the sales invoices to
update the sales transaction file, accounts receivable master file, and general
ledger master files since the sales transactions file created in the previous
billing process could be used to update it automatically.

2.3.3

Definition of Collection
The definition of collection in relation with sales cycle is the action performed to
collect the payment as the exchange for the goods and services that had been
delivered to the customers. Some companies establish the collection department
as the separate function which responsible to collect the payment from the
customers.

In certain circumstances, the customers might not able to pay their debt or
runaway to avoid the debt. However, the companies have prepared the
anticipation action to face this problem by estimating the provision amount of
bad debt expenses or uncollectible debts.

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2.3.4

Collection Cycle
According to Arens et al. (2006, p. 414), the collection cycle consist of some
processes that are performed to collect the receivables from customers as the
exchange for goods and services delivered and recording the transaction of cash
receipt. Those processes are:
1. Accept the cash receipts
As discussed by Gill & Cosserat (1996, p. 508), the receiving process of cash
receipts might be performed through:

Over-the-counter receipts
The companies usually assign the collectors who will responsible to
collect the receivable from customers. Then, the collectors will submit
the cash collected to the cashier. After received the cash, the cashier will
give over-the-counter receipts which is usually generated from the cash
register or point-of-sale terminal. These devices are used to reduce the
possibility of theft toward cash.

2. Depositing the cash receipt

Arens et al. (2006, p. 414) stated that the main consideration of handle cash
receipts is all of the cash received in a day should be deposited in the bank at
the correct amount as stated in the remittance list. In addition, the cashier
should also record the cash receipts transactions that can be used to generate
the cash receipt journal and update the accounts receivables and general
ledger master files.

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3. Recording the cash receipt transaction
In this stage, the companys staffs who responsible to record the cash receipts
transaction should ensure that they had recorded valid transaction. Moreover,
according to Gill & Cosserat (1996, p. 509), the companies who use over-thecounter receipts, usually record the transaction in general ledger by using the
data generated from the daily cash summary prepared by the cashier.

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2.4

Operational Audit on Sales and Collection Cycle

2.4.1

Stages Performed in Operational Audit on Sales Cycle

According to Arens et. al (2006, p. 416-417), the auditor should perform several
stages in conducting the operational audit on sales cycle. Those stages are:
1. Planning stage
The auditor should obtain the information regarding client companys sales
operations. Therefore, the auditor might use the information to assess the
risks that might be associated with the companys internal control of sales.

2. Preliminary study stage

In this stage, the auditor could assess the control risk associated with sales by
performing some procedures that are:

Identify the existing control of sales implemented by the company;

Identify the sales transaction-related audit objectives, as stated by Arens

et. al (2006, p. 420-421):
i.

Existence
Recorded sales are for shipments actually made to customers.

ii.

Completeness
Existing sales transactions are recorded.

iii.

Accuracy
Recorded sales are for the amount of goods shipped and are
correctly billed and recorded.

iv.

Classification
Sales transactions are properly classified.

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v.

Timing
Sales are recorded on the correct dates.

vi.

Posting and Summarization

Sales transactions are properly included in the accounts
receivable master file and are correctly summarized.

Determine the key internal controls and weaknesses found in the clients
company;

Correlate the weakness found with the objectives;

Evaluate the control risk associated with every sales transaction related
audit objectives.

3. Implementation Stage
In this stage, the author should design the audit programs that consist of
several audit procedures including the types of audit tests that are needed to
be performed to obtain the evidences. For instance, the auditor will perform
the tests of control to verify the effectiveness of internal control implemented
in sales cycle of the company.

4. Reporting Stage
After perform all audit procedures, the auditor should create the audit report
that contains the summary of audit findings and it might also include the
recommendations needed to improve the business performance, especially the
sales cycle.

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2.4.2

Stages Performed in Operational Audit on Collection Cycle

The stages performed in operational audit on collection cycle are consists of:
1. Planning stage
The auditor should obtain the information regarding client companys
business operations on collection cycle. Therefore, the auditor might use the
information to assess the risks that are associated with companys internal
control of collection cycle.

2. Preliminary study stage

The auditor should obtain good understanding about the internal control of
collection cycle implemented in the clients company.

Identify the existing control of collection implemented by the company;

Identify the collection of cash receipts transaction-related audit

objectives, as stated by Arens et. al (2006, p. 428-429):
i.

Existence
Recorded cash receipts are for funds actually received by the
company.

ii.

Completeness
Cash received is recorded in the cash receipts journal.

iii.

Accuracy
Cash receipts are deposited and recorded at the amount received.

iv.

Classification
Cash receipts transactions are properly classified.

v.

Timing
Cash receipts are recorded on the correct dates.

vi.

Posting and Summarization

Cash receipts are properly included in the accounts receivable
master file and are correctly summarized.

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Determine the key internal controls and weaknesses found in the clients
company;

Correlate the weakness found with the objectives;

Evaluate the control risk associated with every cash receipts transaction
related audit objectives.

3. Implementation Stage
In this stage, the author should design the audit programs that consist of
several audit procedures including the types of audit tests that are needed to
be performed to obtain the evidences. For instance, the auditor will perform
the tests of control to verify the effectiveness of internal control implemented
in the collection cycle of the company.

4. Reporting Stage
After perform all audit procedures and obtain the findings, the auditor should
create the audit report that contains the summary of the findings and it might
also include the recommendations needed to improve the business
performance, especially for the collection cycle.