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CHAPTER II

THEORETICAL FOUNDATION

2.1 Definition of Operational Audit

Operational audit is an audit which is commonly performed in a company in order to

ensure the effectiveness and efficiency of a company’s operation. Operational audit is

also beneficial in assessing company’s internal control. Inquiries regarding the

accomplishment of company objectives and the compliance of company activities with

the laws and regulations could also be addressed by operational audit. As the result of an

operational audit, recommendations are presented in purpose of resolving company

problems.

According to The Institute of Internal Auditors (IIA) publication cited in Leung, Coram,

Cooper (2007:662), operational audit is defined as:

…a systematic process of evaluating an organization’s effectiveness,

efficiency, and economy of operations under management’s control, and

reporting to appropriate persons the results of the evaluation along with

recommendations for improvements.

Another definition is also provided by Arens, Elder, and Beasley (2003:13), which

describe operational audit as:

…a review on any part of an organization’s operating procedures and

method for the purpose of evaluating efficiency and effectiveness.

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According to Gill (1999:718), operational audit should consist of:

1.Systematic process

Series of logical, structured and organized procedures involved in an operational audit.

Proper planning is very important in an audit in order to obtain and evaluate evidence

relating to the activity being audited.

2.Evaluating an organization’s operation

Every company’s management owns its performance standards which are expressed as

criteria. The degree of correspondence between actual performance and the criteria are

measured by an operational audit.

3.Effectiveness, efficiency, and economy of operations

The main purpose of an operational audit is to assist the client or the company audited

in improving the effectiveness, efficiency, and economy of its operations.

4.Reporting to appropriate persons

The appropriate recipient of the operational audit is the management or the individual

agency that requested the audit

5.Recommendations for improvement

Recommendations are the result of the operational audit conducted by the auditor.

In summary, operational audit is a systematic and objective evaluation of a company’s

activities, with the purpose of providing recommendations and improving the

effectiveness and efficiency of the company.

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2.1.1 Purpose and Benefit of Operational Audit

There is major distinction between financial and operational audit. The orientation

between these audits is also dissimilar. Financial audit is oriented to the past, whereas

operational audit concerns for the future.

Purposes of an operational audit, according to Carmichael and Willingham (1987:544),

are:

1. Assess performance

In assessing company’ s performance, the auditor needs to compare the manner in which

an organization conducts its activities, in accordance with (1) objectives established by

management or the engaging party, such as organizational policies, standards, and goals,

and (2) other appropriate measurement criteria.

2. Identify opportunities for improvement

Several alternatives for auditor to identify specific opportunities for improvements are

analysis of interviews with individuals, observation of current operations, reviews of

past and current reports, transaction studies, comparisons with industry standards,

exercise of professional judgment based on experience, or other appropriate means.

3. Develop recommendations for improvements of further actions

Recommendations could be made by the auditors. In certain cases, it is possible for the

auditor to conduct further study, not within the scope of the engagement, and the auditor

may simply refer to reasons why further study of a specific area may be appropriate.

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Implementation of operational audit is expected to assist the companies in achieving

certain benefits, such as generating progress for the company performance, increasing

the management of company operations.

Companies may have different purposes in conducting operational audit. Nevertheless,

the main objective is improving effectiveness and efficiency of operations in the short

term and increasing company performance in the long term.

2.1.2 Types of Operational Audit

There are three main categories of operational audit which auditors frequently perform.

In every types of operational audit, the main objectives are evaluating internal control

and assessing company’s efficiency and effectiveness.

Arens (2003:740) categorize three main types of operational audits:

1. Functional Audits

Functions are a means of categorizing the activities of a business, such as the billing

function or production function. Various methods have been developed to categorize and

subdivide functions. Prior to the terms, a functional audit is conducted with one or more

functions in a company. Specialization by auditors is permitted in this type of audit.

This specialization has become the main advantage of functional audit.

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2. Organizational Audits

Organizational audit deals with an entire organizational unit, including all departments,

branches, and subsidiaries. The organization operation and also methods are especially

important in this audit. Therefore, this audit is ideal in order to emphasize how

efficiently and effectively functions interact

3. Special Assignments

Management usually raises the request of special assignment. Examples of this audit

may include determining the cause of an ineffective IT system, investigating the

possibility of fraud in a division, and making recommendations for reducing the cost of

manufacture product.

Several aspects affecting the type of audit performed are the scope permitted by the

company, the benefits expected to be achieved, and request from the company.

2.1.3 Performance of Operational Audit

As in other kinds of audit types, it is crucial that operational audit is to be performed by

competent auditors.

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As stated by Arens (2003:740-742), operational audit is performed mainly by three

professions:

1. Internal Auditors

Internal auditors could perform either operational or financial audits. These auditors are

considered to be effective for the company because normally, they also work for the

company audited. However, in an audit performance, internal auditors are obliged to be

independent. The internal auditors should report to the board of directors or president.

2. Government Auditors

Government auditors usually perform financial audit and also operational audit. In

Indonesia, government auditors are represented by Badan Pemeriksa Keuangan (BPK).

The result of an operational audit by BPK would be presented to Dewan Perwakilan

Rakyat (Legislative Council) as a means in managing Indonesia’s economic activities

(Jusup, 2001:17). In United States, General Accounting Office (GAO) is the most

widely recognized government auditor group. The standard for government auditors in

United States is termed ‘The Yellow Book’, which defines and sets standards for the

performance audits; which are considered essentially the same as operational audits. The

objectives of performance audit based on ‘The Yellow Book’ are economy and

efficiency audits and also program audits.

3. CPA Firms

CPA firms perform their audit based on their knowledge of client’s background. They

usually perform financial audit and could be widened into operational audit. The result

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of the audit should be made in form of management letter. Operational audit by CPA

firms commonly happen in a company which lack of internal audit staff or internal audit

staff lacks expertise in a certain area.

In general, auditors should possess their independence in performing operational audit or

other types of audit. In the performance of any type of operational audit, auditors are

expected to resolve the matters in an uncomplicated manner and presented the result in

recommendations. These recommendations should be able to be conducted effectively

and efficiently by the company.

2.1.4 Phases in Operational Audit

In managing their working schedule and also services, it is beneficial for auditors to

have phases in operational audit.

The phases that need to be completed in an operational audit are (Gill, 1999:718-721):

1. Audit Planning

In audit planning, auditors should determine the scope of the engagement and

communicate it to the company; obtain background information about the company,

comprehend internal control, and decide the appropriate evidence to accumulate. Audit

planning begins by developing an audit program. Audit program is composed based on

the findings by the auditor in the preliminary study phase. Scheduling the audit

performance is also included in audit planning. In operational audit, it is crucial to spend

more time with interested parties regarding the terms of engagement and the criteria for

evaluation.

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2. Audit Performance

In acquiring relevant data, the auditor usually conducts inquiry and observation.

Questionnaire is the most common approach used by the auditor as a basis for

interviewing auditee personnel. The auditor expects to obtain opinions, comments, and

suggested solutions from the responses. Auditors can also conduct observation of

auditee personnel to detect inefficiencies and other weaknesses.

The next phase in audit performance is analysis. Analysis is also important because it

provides a basis for determining the degree to which the auditee is meeting specified

objectives. Analysis comprises of the study and measurement of actual performance in

relation to some criteria.

There are two types of criteria, which are criteria internally developed by the entity and

criteria externally developed by the entity. Internally developed criteria could be

described in productivity goals and budgets. Externally developed criteria could also be

found in information on industry standards or derived by the auditor from previous

audits or similar activities. After the audit performance concluded, the auditor should

document the findings and the recommendations in working papers. The senior auditor

usually will review the working papers to monitor progress and ensure the overall

quality of the work.

3. Report Findings

The result of operational audit is the audit report. In operational audit, the report is

usually sent only to management, with a copy to the unit being audited. The common

features of an operational audit report comprise of:

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a. A statement of objectives and scope of the audit

In this stage, auditor would include (1) document, analysis, and report regarding the

current operations (2) identification of areas that require attention (3) recommendations

for corrective action or improvements. The components of the scope are identification of

units being audited and the evaluation of specific financial and operational conditions.

b. A general description of the work done

In this section the auditor will indicate (1) the personnel interviewed; (2) the specific

documents, files, reports, and systems used in evaluation; (3) the analysis of data; (4) the

development of recommendations for improvement; (5) the discussions with

management personnel.

c. A summary of findings

For consideration purpose, all substantial findings are included in the report.

• Recommendations for improvements

The aim of recommendations is to increase the efficiency and effectiveness of

company’s operation.

• Comments of the auditee

This feature is optional for auditors. Auditors will include this part only when there is

disagreement with the auditee concerning findings and recommendations.

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4. Follow-up Performance

The auditor is required to follow up on the auditee’s response to the audit report. The

failure in receiving an appropriate response must be reported to senior management by

the auditor.

Subsequently, the phases in operational audit is required to be achieve several goals ,

such as (1) to ensure the effectiveness and efficiency of company activity, (2) to assist

the company in improving its operations and developing the performance.

2.2 Definition of Internal Control

One of the purposes of operational audit is also to evaluate efficiency and effectiveness

of internal control and eventually provide recommendations to the management.

In accordance with Agoes (1999:180), efficiency and effectiveness were defined as

follows:

a. Effective occurs when a company could accomplish its goal, objectives, or programs

in a targeted range of time, regardless of the cost.

b.Efficient occurs when a company could achieve bigger results (output) along with the

least amount of cost (input).

Accordingly, concise explanation of effectiveness and efficiency are:

a) Effectiveness - the assessment of a company in determining the extent the company

has been successful in realizing its goal, objectives, or programs.

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b) Efficiency - correlation between the output results of the company’s activity and the

input consumed to generate the results (output).

Furthermore, Auditing and Assurance Handbook 2008 ( ASA 315: 218), affirm that,

‘obtaining an understanding of the entity and its environment, including its internal

control is a continuous, dynamic process of gathering, updating, and analyzing

information throughout the audit.’

In accordance with The Committee of Sponsoring Organizations (COSO) of the

Treadway Commission, (Gill, 2004: 273), internal control can be defined as:

…a process, affected by an entity’s board of directors, management, and

other personnel, designed to provide reasonable assurance regarding the

achievement of objectives in the following categories: reliability of

financial reporting, compliance with applicable laws and regulations, and

effectiveness and efficiency of operations.

The definition of internal control according to Ikatan Akuntan Indonesia (IAI),

published in Standar Profesional Akuntan Publik (IAI, 2001:319.2), is:

Internal control is the process carried out by the commissioner,

management, and the staffs in the entity, which is designed to provide

reasonable assurance in accomplishing three main purposes: (a) reliability

of financial reporting (b) efficient and effective company’s operations (c)

compliance with the rules and regulations.

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A company’s size has an essential effect on the nature of internal control. However, if

the various subcomponents of internal control are examined, it becomes obvious that

most are applicable to both large and small companies.

2.2.1 Purpose of Internal Control

Three purposes of applying internal control in a company are (1) Reliability of financial

reporting, (2) Compliance with rules and regulations, and (3) Efficiency and

effectiveness in company activities.

Standar Profesional Akuntan Publik (IAI, 2001:319.2) identifies the purpose of internal

control as follows:

1. Reliability of financial reporting

Management has the obligation of establishing and maintaining entity’s controls.

Therefore, the management should ensure that the financial report has been prepared

according to reporting standard.

2. Effectiveness and efficiency of the company’s operations

By applying good internal control, it is anticipated that ineffective and inefficient use of

resources could be diminished.

3. Compliance with the law and regulations

The company’s operations should be complied with rules and regulations, which could

affect the company directly or indirectly.

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As a conclusion, by applying the appropriate degree of internal control in a company,

the company could achieve its short term and long term goal in an efficient and effective

way.

2.2.2 Components of Internal Control

Internal control includes five significant categories that management designs and

implements to provide reasonable assurance that management’s control objectives will

be met. These are called the components of internal control (Arens, 2003:274-281)

1. The control environment

Control environment consists of the actions, policies, and procedures that reflect the

overall attitudes of top management, directors, and owners of an entity about internal

control and its importance to the entity.

In understanding and assessing control environment, auditors should also consider other

subcomponents such as integrity and ethical values, commitment to competence, board

of directors or audit committee participation, management’s philosophy and operating

style, organizational structure, assignment of authority and responsibility, and human

resource policies and practices.

2. Risk Assessment

Risk assessment for financial reporting includes identifying and analyzing risks which

are relevant to the preparation of financial statements in conformity with Generally

Accepted Accounting Principles (GAAP).

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In order to understand more about risk assessment in a company, auditors usually could

use control risk matrix which described control which needed for certain function in a

company, perform questionnaires and discussion with management. Relevant transaction

class audit objective in control risk matrix consist of completeness, existence and

occurrence, allocation and valuation, and presentation and disclosure. The more

effective the internal controls, the lower the control risk and inherent risk. The

relationship between control risk and detection risk is inversed, whereas the relationship

between control risk and substantive test is direct. Thus, when the control risk and

inherent risk are high, substantive test is needed. And when the detection risk is high,

test of control is needed.

3. Control Activities

Control activities are the policies and procedures, which help ensure that necessary

actions are taken to address risks in the achievement of the company’s objectives.

Statements on Auditing Standards (SAS) 94 and COSO Report note that control

activities are generally related to policies and procedures that affect segregation of

duties, information processing, physical controls, and performance reviews. There are

five types of specific control activities, which are adequate segregation of duties, proper

authorization of transactions and activities, adequate document and records, physical

control over assets and records, and independent checks on performance.

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4. Information and Communication

The role of information and communication system within a company is to initiate,

record, process, and report the entity’s transactions; and maintain accountability for the

related assets. To understand the design of the accounting information system, the

auditor (1) determines the major classes of transactions of the entity, (2) how those

transactions are initiated and recorded, (3) what accounting records exist and their

nature, (4) how the system captures other events that are significant to the financial

statements, and (5) the nature and details of the financial reporting process followed.

5. Monitoring

Monitoring activities deal with the ongoing or periodic assessment of the quality of

internal control performance by management to determine that controls are operating as

intended and that they are modified as appropriate for changes in conditions.

The major types of monitoring activities a company uses and how these activities are

used to modify internal controls when necessary are the most important things the

auditor needs to know about monitoring. The most common way to obtain this

understanding is by discussion with management. In addition, an adequate internal audit

staff can reduce external audit costs by providing direct assistance to the external

auditors.

Each component of internal control comprises of policies and procedures which are

considered necessary in attaining the purposes of internal control.

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2.2.3 Relation between Operational Audit and Internal Control

Analyzing and evaluating internal control of a company is required for an auditor, as

stated by Standar Profesional Akuntan Publik (IAI,2001:319.02), ‘Reasonable

knowledge of internal control should be acquired with the aim of planning the audit and

determining the nature, timing, and extent of the audit’.

Ratliff (1996:753) defines the relation between internal control and operational audit as

follows, ‘Operational audits examine and evaluate systems of internal control and the

quality of performance in carrying out assigned responsibilities’.

He further states that the key to understanding operational auditing is to understand

internal control. All operational audit tests generally are linked directly to some aspect

of organizational operations (Ratliff, 1996:753-757). Therefore, it is certain that

operational audits are conducted to enhance and support internal control as means in

achieving company’s goals.

Weaknesses in company’s internal control, such as errors, inaccuracy and fraud, indicate

greater risk for the company. If the auditor assumes the company’s internal control as

ineffective, the auditor should expand the audit scope and perform substantive test in

preventing greater risk to occur. On the contrary, if the auditor presumes the internal

control of the company as effective, the auditor could simply complete test of control or

reduce the scope of the audit when performing substantive test.

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2.2.4 Definition of Accounting Information System

In performing operational audit, particularly in describing the flow of company’s

operation and also its organizational structure, the audit is supported by accounting

information system.

According to Hall, information system could be defined as:

‘Specialized subset of information system that processes financial transactions

(Hall, 2007:9).’

Hall also stated several documentation techniques which support the performance of

operational audit, such as (2007: 58-62):

1. Data Flow diagrams

In this method, symbols are representing the entities, processes, data flows, and data

stores that pertain to a system.

2. Entity Relationship Diagrams

This method applies documentation technique to represent the relationship between

entities.

3. Flowcharts

A flowchart is a graphical representation of a system that describes the physical

relationship between key entities.

Components in accounting information system maintain a proper performance of an

operational audit.

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2.2.5 Relation between Operational Audit and Accounting Information System

In Operational audit the main purpose is to assess the internal control of the company in

order to evaluate the company’s performance. In assessing the internal control, there are

methods applied.

This method applied is frequently related to accounting information system. Accounting

information system could provide the written description of a system which could be

wordy and difficult to follow. By using documentation techniques, the auditors could

capture visual image which could convey vital system information more effectively and

efficiently than words do. For example, the auditor needs to evaluate the internal control

and procedures of purchasing department in the company; the auditor could use a

flowchart to describe this situation. The auditor will begin by interviewing individuals

involved in the purchase order process to determine what they do. Based on the findings

and facts, the auditor could create a flowchart of this system. This flowchart would

clearly identify the system that it represents.

2.3 Definition of Purchase

Within a company, there are areas which possess high risk factors. One of these areas is

the purchasing area. In a company, purchase is the main function in maximizing

company’s production activity. Purchase volume depends on the size of the company.

There are several definitions of sales, including:

1. According to Ebert and Griffin ‘Purchasing is the acquisition of all the raw materials

and services that a company needs to produce its products’ ( Ebbert and Griffin, 2005:

210).

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2. In accordance with Soemarso, ‘ Purchasing activity could include, purchasing goods

in cash or credit, purchasing goods for the purpose of production activity and other

company activities’ (Soemarso, 1999:208).

In summary, purchase could be defined as the result of company’s activity in acquiring

production goods within a period of time. Purchase is performed in two ways:

1. Cash purchase

In this type of purchase, the company is obliged to make the payment alongside the

acceptance of merchandises ( Arens, 2003:542).

2. Credit purchase

This type of sales enables the company to receive the merchandises and make the

payment afterwards, within an agreed upon of time and terms. Accounts payable occur

as the result of credit purchase ( Arens. 2003:543).

2.4 Definition of Account Payable

Lenience in terms of payment may be provided for the company by the seller, such as

permitting the company to make payment within an agreed period of time and terms.

Lenience in payment only occurs in credit purchase.

Account payable in credit purchase is regarded as a liability due to the obligation that a

company expects to fulfill in the future. In accounting manner, account payable is

considered as current liabilities. Current liabilities are obligations which fall due before

one year from the balance sheet date.

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There are several definitions for account payable, such as:

1. Horngren (2002:329) defines account payable as ‘Amounts owed to suppliers.’

2.According to Nickels, McHugh, McHugh, accounts payable could be defined as,

‘Money owed to others for merchandise and services purchased on credit but not yet

paid ‘(Nickels: 558).

3.Arens, Alder and Beasley defined accounts payable as:

Unpaid obligations for goods and services received in the ordinary course of business

(Arens, 2003: 552).

2.5 Summary of Theoretical Foundation

Operational audit is conducted as a review of company’s activities. The benefits of

operational audit are assessing the company performance, identifying weaknesses in

company functions, increasing efficiency and effectiveness of company operations, and

providing recommendations for the development of the company. There are three types

of operational audit which are commonly performed by auditors; they are functional

audit, organizational audit, and also special assignment. The stages usually pursued in

operational audit are audit planning, audit performance, report findings, and audit

follow-up.

Enhancing efficiency and effectiveness of company operations has become the main

purpose of operational audit. Effectiveness and efficiency are crucial in a company

because by enhancing both of them; a company can easily manage its operations and

accomplish its objectives.

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Internal control should also be reviewed by auditors in conducting operational audit. In

performing internal control, management should also consider the components of

internal control, such as control environment, risk assessment, control activities,

information and communication, and monitoring.

Proper application of internal control could ensure the reliability and compliance of

financial reporting, and also increase the level of effectiveness and efficiency of the

operations.

In providing the visual description of the internal control of the company, the auditor

would apply the documentation techniques in accounting information system. These

documentation techniques would provide great amount of assistance in understanding

more about the company’s operation and relation between entities audited.

Credit purchase could be considered as an obligation which must be fulfilled by the

company. Account payable is also crucial because if the company could not pay their

account or could not be resolved, the amount in the account payable could affect the

company performance in negative way.

The objective of this thesis is to perform operational audit on credit purchase and

account payable functions on fabric at PT. Henrydew Putra Sanjaya. Prior to the

situation in PT Henrydew Putra Sanjaya, the type of operational audit which will be

conducted is the functional audit. By conducting operational audit, it is expected that the

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auditor could identify the weaknesses of the company in both functions and

subsequently provide recommendations to prevent future losses and risks. This audit

performance is also conducted to evaluate the level of internal control in the company.

Eventually, this audit could increase in effectiveness and efficiency of company activity

especially in credit purchase and account payable on fabrics. This audit would also be

performed based on the proper audit phases.