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MANAJEMEN AUDIT

Dosen : Syamsu Alam, SE., Ak. M.Si.

MODUL 7

UNDERSTANDING MANAGEMENT CONTROL

R E F E R E N S I

1. Herbert Leo, Ph.D. Auditing the Performance of Management,1979.

2. Setiawan Johni, Pemeriksaan Kinerja, BPFE, Yogyakarta. 1988

3. Widiyanto Nugroho, Pemeriksaan OperasionalPerusahaan, LP. FE-UI, Jakarta, 1980.

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MODUL 7

UNDERSTANDING MANAGEMENT CONTROL

After you have read this chapter, studied the review questions,and worked through the cases, you will understand:- The meaning and scope of management control.- Selected standards for management control.- How to review management control, including how to develop

questionnaires and flow charts, and how to test transactions.

A. Introduction to Management Control

Internal control as related to a financial-statement examination, and mana-

gement control as related to a performance audit, have similar characteristics but

somewhat different purposes. Accountants who make financial-statement exami-

nations understand that internal control relates to the competency of evidence

needed for such examinations. In Chapter 2, which dealt with the phases of the

audit function, we stated that there were two purposes for the review and testing of

management control: One was to test the management control to develop

evidence to determine if the tentative objective could be developed into a firm

audit objective; and the other was to determine the competency of evidence

obtained from the system of internal management control.

This second purpose relates strongly to review of internal control for a

financial-statement examination. The auditor determines the competency of infor-

mation obtained from the system of internal accounting control to determine

whether he can rely on it for guidance as to the extent of the tests he must make in

the detailed examination.

The auditor who is new in performance auditing must clearly understand

the purposes of management control and just how these differ from his experiencein making financial-statement audits. Management control in performance auditing,

he will find, encompasses both internal and external control. Let us start, then, by

defining internal control and management control.

B. Meanings of Internal Control and of Management Control

Concerning the meaning of internal control for financial-statement exami-

nations, the American Institute of Certified Public Accountants (AICPA) states:

Internal control, in the broad sense includes…… controls which may be

characterized as either accounting or administrative as follows:

Pusat Pengembangan Bahan Ajar - UMB Syamsu Alam, SE., Ak. M.Si MANAJEMEN AUDIT

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27 Administrative control includes, but is not limited to, the plan of organization and the procedures and records that are concernedwith the decision processes leading to management's authori-zation of transactions…. Such authorization is a managementfunction directly associated with the responsibility of achieving theobjectives of the organization and is the starting point for establishing accounting control of transactions.

28 Accounting control comprises the plan of organization and theprocedures and records that are concerned with the safeguardingof assets and the reliability of financial records and consequentlyare designed to provide reasonable assurance that:

a. Transactions are executed in accordance withmanagement's general or specific authorization.

b. Transactions are recorded as necessary (1) topermit preparation of financial statements in

conformity with generally accepted accountingprinciples or any other criteria applicable to suchstatements and (2) to maintain accountability forassets.

c. Access to assets is permitted only in accordancewith management's authorization.

d. The recorded accountability for assets iscompared with the existing assets at reasonableintervals and appropriate action is taken withrespect to any differences.

Based upon this description of internal control, the AICPA discusses thecharacteristics of a good internal accounting control system, as follows:

1. Reasonable assurance that the objectives of accounting control are

achieved depends on the competence and integrity of personnel. the

independence of their assigned functions, and their understanding of the

prescribed procedures.

2. Functions are adequately segregated. Incompatible functions for ac-

counting control purposes are those that place any person in a position both to

perpetrate and to conceal errors or irregularities in the normal course of his

duties.

3. Obtaining reasonable assurance that transactions are executed as au-

thorized requires independent evidence that authorizations are issued by

persons acting within the scope of their authority and that transactions conform

with the terms of the authorization.

4. In respect to the recording of-transactions, they should be recorded at the

amounts and in the accounting periods in which they were executed and be

classified in appropriate accounts.


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5. Access to assets should be limited to authorized personnel.

6. Actual assets should be compared with recorded accountability.

Standards for internal accounting control are thus readily available, even

though sometimes they are not accepted and used as a basis for verification by

comparison with actual operations. For management control, however, a field that

embraces all activities inside and outside of the organization that pertain to the

operation of the organization and its internal administrative control, standards are

not as readily available. Many have never been developed; or if developed, they

apply to the specific organization only. These standards would include strategic

plans, operating plans, organization plans, personnel requirements, resource

requirements, and all other planning and operating needs of the organization.

When these management and administrative controls have not been developed or

are not appropriate to the activities of the organization, there is a possibility of

inefficient, uneconomical, or ineffective operations.

In addition, many transactions have a direct bearing on the operations of an

organization that do not take place exclusively within the organization. The law, for

example, determines what a corporation can do, and society often regulates that

corporation by comparison with the law: regulatory agencies determine for the

organization such environmental considerations as equal employment opportunity,

air pollution, and water pollution. Market conditions, borrowing conditions, and

technological considerations are all activities outside an organization that can

affect its internal operations. The parent corporation, also, may impose outside

restraints: on divisions; profit controls and pricing controls are examples. .

Today in our country we see that more and more activities are being

controlled by external standards. Almost all government social programs are

carried out by organizations other than the ones originally given the responsibility.

Health programs, for instance, are carried out by local organizations, including

hospitals; research programs are carried out by universities or local research

groups; energy programs are carried out by many individuals and organizations.

Almost all military procurement, moreover, is accomplished through defense

contractors; even space vehicles have been obtained through independent

contractors.

In the field of private enterprise as well, large corporations are now using

independent contractors for making many of the products they use or sell

Independent contractors, for example, make engines for automobiles, refrigerators


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for other corporations to sell, and railroad trains to carry specific types of

passengers or freight.

Some verification for each of these activities must take place if management

is to be assured that its employees comply with given standards. To assure

compliance with both the external as well as the internal standards, management,

then, will always have some sort of a management control system--good or bad.

We see, thus, that as we stated at the beginning of this chapter, manage-

ment control will encompass not only internal but external control. Restricted to

internal activities, however, management control and internal administrative

control mean exactly the same thing.

Now let us define management control as we are using it in performance

auditing and list some of the characteristics of good management control:

Management control is the plan of organization and all other plans,policies, procedures, and practices needed by personnel and other resources to achieve the objectives of the entity.

The objectives of the entity should include not only the stated resultsexpected from the production of goods or the rendering of services, butalso a statement of the responsibility of management for the safe-guarding of the resources and the accountability for the results.

A good system of management control would include the following:

1. A statement of the objectives of the entity,2. A plan of organization for accomplishing the objectives,3. Personnel of a quality and quantity commensurate with their respon-

sibilities, with adequately segregated functions,4. An established system of appropriate policies and practices for each

department or entity, and5. An effective system of review at all levels of activity to assure the

carrying out of the established system of appropriate policies andpractices.

Distinctions and Similarities Between Internal control and Management

Control

There are many similarities between management control and internal

Control, and yet there are important distinctions-principally in three areas:

1. increased emphasis on the need for a statement of objectives for the entity

and the tie-in of management control to that statement of objectives,

2. increased emphasis on external control as compared to internal control,

and


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3. the expansion of control to include all activities of management, such as

production, transportation, and research, rather than emphasis only on

accounting activities.

Objectives of the Entity

Seldom can an organization be effective unless it knows what it is supposed

to do. Efficient and economical practices are rather meaningless unless the prac-

tices produce a meaningful product or service. A saying rather common a few

years ago was that the most efficient producer of buggy whips in the world went

out of business because the end result was that there was no demand for buggy

whips.

Yet, many governmental and private organizations still operate on the

principle of how something is done rather than what is to be done or why. It has

only been within this century that the legislative bodies of most governmental units

have tried to tell thy executive branch what they want and leave it to the executive

branch to determine how to do it. In many private corporations too, the chief

executive may have known what was wanted, but seldom did anyone under him

know. Their responsibility was to carry out what they were told to do. Most

government agency and private organization officials were administrators rather

than managers, administering laws, regulations, policies, and procedures. Their

responsibility did not include the development of what should be done and why it

should be done.

Today, however most well-managed organizations, both public and private,

profit and nonprofit, understand the need for communicating the basic objectives

of the organization to all levels of operations. We are using the term objectives

here to mean the long-range, fairly broad statements of what the organization

desires to achieve. Goals, strategies, and results desired are terms used for a

shorter range, more specific desired achievement. Both concerns need to be well

stated in order to develop operating plans and procedures that will achieve them in

the best manner possible. An organization is effective when it achieves its

objectives. It is economical and efficient when its methods of achieving its goals

and objectives accomplish the results in the best manner possible under the

circumstances.

M-audits for efficient and economical practices are often made without any

reference to the objectives of the organization, particularly when the audit is for determining the compliance with a law, regulation, policy, or stated procedure by


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the employees or management. Yet, when the management of a firm is audited to

determine whether the methods and activities they carry out are related to the

objective of the entity, an M-audit becomes genuinely helpful, as a way to improve

the management rather than merely to improve the administration of a particular

standard.

Plan of Organization

After considering the objectives of an entity, the next step an auditor should

take in evaluating management control is to see that the entity is properly

organized to carry out its objectives. He should see that responsibilities are

properly divided, that each executive has been given authority commensurate with

his responsibilities, and that no one person has control of all phases of an

operation. He should also see that each person is accountable to some third party

for his actions and that each accountable person's actions are reviewed to

determine that his assignments are properly carried out. A properly designed

organization chart will give some of this information.

Organization Charts

Figure 7.1 represents a typical organization chart for an industrial company--

although an auditor would need more Information than is here presented, such as

a statement of the responsibilities for major executives, for instance.

Figure 7.1 Organization chart: typical manufacturing organization

Organization charts very somewhat in accordance with the objectives and

responsibilities of the organizations. Another typical organization chart is that for

the state agency responsible for state cars, discussed as Case 1 in Chapter 3, and

illustrated here in Figure 7.2 The auditor in this case would also have to consider

the organization charts for any agency he audits on the activity of buying gasoline

for state cars. For example, he might audit a state university for this activity; he

would have to know which departments granted other departments in the

university the right to use state-owned automobiles for state travel, whether the

automobiles were, leased or bought, whether the department instructed the drivers

of the vehicles where they should buy gasoline, and other information needed by

the driver of the car.


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Figure 7.2 Organization chart: state administrative agency

From this example, the auditor can begin to see the complexities of external

management control in an M-audit-the audit for efficiency and economy. The most

complex organizations, however are those that deal with programs, Figure 7.3

shows just how complex an organization chart can become when it reflects, the

interrelationships of a program among organizations.

Flow Charts

A plan of organization as reflected in an organization chart does not show

the flow of transactions between organizations. The visualization of this flow is

best seen in a flow chart, and standard symbols have been developed to show this

flow in an electronic data-processing system. However since the flow of many

transactions in a performance audit is for manual transactions as well as for

electronic transactions and may take the auditor outside of the organization in

which he normally works, he may want to adapt the standard flow-chart symbols to

meet his need. If he does change the symbols, he must identify them clearly so

that anyone reading, the flow chart can understand it.

Figure 7.4 shows the most common standard symbols used in flow charting an

electronic data-processing system; symbols used for flow-charting a particular

activity are given in Figure 7.5, which illustrates material in Case 1 of this chapter.

The auditor normally will make a rough draft of the flow of transactions when

he is interviewing selected officials and employees or observing actions of these

individuals during the preliminary survey and review phases of the audit. It may be

noticed, too, that in flow-charting a performance audit transaction, more

descriptive information is often placed in the chart as in figures 7.5 and 7.6.

Personnel and Their Functions

No organization can expect to operate satisfactorily unless duties and

responsibilities are adequately separated, and persons are provided in the

organization who are capable of carrying them out.

In looking over the requirements for a good management control system

pertaining to personnel, the auditor would ask the following kinds of questions:

1. Have the requirements of the job been adequately stated?2. Are personnel recruited who are qualified to fill the responsibilities of the job?3. Are there sufficient personnel available to accomplish the work?4. Is training given to improve the quality of work performed?5. Is there proper supervision?


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6. Do employees understand not only what they are doing but why they are doingit?

Auditors who make financial-statement examinations have been concerned

with people and their a counting functions for a long time, especially the adequate

separation of functions. Now, the responsibility of the performance auditor extends

to personnel of all types. It is just as important that the person who leases

automobiles knows his responsibilities and is able to achieve those responsibilities

as it is for a person who keeps records of accounts receivables and inventories to

do his job properly.

When the audit involves different levels of the organization(s), the respon-

sibility for communication between the levels must be specifically determined.

Unless the lower levels know and understand-what is wanted from the higher

levels, it is difficult or impossible to achieve what is wanted.

In government, laws and regulations are often the controlling standards for

personnel. When the quality of personnel is incapable of achieving effectiveness in

a government program and that quality is the result of archaic laws or wrong

interpretations, there should be some consideration for change; and the auditor

will find it necessary to so indicate to the proper level of government.

Appropriate Policies and Practices

Appropriate policies and practices result from adequate long- and short-

range planning, and such planning comes about more often than not when the

organization has well-defined objectives. What is wanted by the organization, as

well as what is wanted from the individual, should be appropriately communicated

if efficient, economical, and effective operations are desired. Policies are usually

communicated in the form of policy manuals. However what is in the policy manual

might or might not be what is actually being done, and it is this the auditor must

discover rather than merely reading the policy and procedures manuals.

A System of Review

Effective management of any activity requires advance planning in terms of a

specific standard for operations, actions, or transactions. Management must also

plan for resources in the form of personnel, materials, and funds. Further they

should prescribe or suggest schedules, or targets for accomplishment and where

practicable, use standards for measuring efficiency of performance.

The auditor should examine these existing plans in whatever form they are

used when he surveys an activity. He should also inquire into the methods


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followed by management itself when comparing actual performance with planned

operations. This technique will provide the auditor with direct insight into the

relative strength and weakness of the entire system of management control. It Can

also help him identify those problems warranting his particular attention and more

comprehensive examination.

Furthermore, the auditor should ascertain how supervisory officials determine

the following: whether (1) prescribed policies are being followed, (2) the

procedures are being followed in an efficient and economical manner and (3)

authorized and prescribed procedures are effective.

Management should also be using internal reporting and internal audit

methods, and the auditor should obtain complete information as to these functions.

He should consider the nature and effectiveness of internal review and reporting

methods in relation to each activity under review.

Direct supervision is another important review element in a good system of

management control, since supervisory methods are crucial in determining causes

of deficient operations.

When the auditor of financial statements prepares to review the internal

control of an organization, he has three different approaches: questionnaires,

usually somewhat uniform; flow charts; and testing transactions. When the

performance auditor however approaches the review of management Control of

an organization or program, he usually has two ways only to begin his evaluation:

flow charts, and testing transactions.

No activity has been reviewed sufficiently to develop standardized

questionnaires for the review of management control of that activity, and therefore

the performance auditor does not have such questionnaires he can use. However,

the auditor will ask certain types of questions concerning the management control

when testing specific transactions or items. This review should be in sufficient

depth to enable him to obtain practical working information. The following types of

questions are useful in order to obtain the evidence an auditor will need either to

firm up his tentative objective or to determine whether information from the

management control system is competent:

1. How are the operations actually carried out?2. Are the various steps in the processing of transactions needed or useful?3. Are the results of the transactions accomplished in terms of agency objectives,

legal requirements, and common-sense practices4. What is the effectiveness of the control provided?

5. Does the system provide satisfactory control over costs, expenditures,receipts, revenues, and resources?


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6. Do the organization's practices protect the interests of third parties, such astaxpayers, stockholders, or higher levels of management?

7. Is there duplication of effort?8. Are available funds used properly and wisely?9. Does management accept proper responsibility?10. Does management control funds or activities?11. Is there a cumbersome or extravagant organizational pattern?12. Are the personnel capable of doing the work?13. Are both personnel and physical resources used effectively?14. Is there a genuine need for various operating and service units in relation to

the costs of maintaining them?15. Is there an effort to overcome any backlog? .16. Are standards established and being used by officials in judging factors

requiring management appraisals?17. Are written procedures and policies clear, or are there differing or inconsistent

interpretations by various people?

If the auditor obtains appropriate answers to these kinds of questions, he will

obtain a basic and a thorough knowledge as to how the operations being reviewed

are actually carried out. He will obtain as well an insight into the effectiveness of

the system of management control. Such knowledge is essential as a basis for

planning the further work necessary to examine the efficiency, economy, and

effectiveness of the controls provided by the organization's system of planning and

practices.

This type of testing will also allow the auditor to obtain evidence on all three

elements oJ the tentative audit objective-criteria, causes, and effects, which he

can then consider along with such evidence found in organization manuals.

Examining management reports and internal audit reports, inspecting

activities involved, and conducting discussions with responsible officials and

personnel, can further help the auditor to obtain evidence on the tentative audit

objective concerning the weaknesses in the management control system of the

organization. The particular circumstances encountered and the specific objectives

established for each assignment need to be given appropriate consideration in

determining the nature and the extent of the work necessary in a given instance.

No hard and fast rules can be established as to the amount or type of work to

be done, or the techniques to be used, in testing management control. The

judgment and ingenuity of the audit staff play a large part: their approach should

be tailor made in each situation. It is important, nevertheless, that the auditor

actually test a certain number of transactions so that he can determine the actual

procedures followed and the actual policies applied by the entity, as well as

identify some evidence on the three elements of the tentative audit objective.


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The actions or transactions selected for review will depend upon the nature of

the organization's activities or programs, along with the preliminary review analysis

that the auditor made concerning the specific components to be considered for

examination. The actions or transactions will represent actual steps, acts, or

processes applied in carrying out an operation for the specific component.

When selecting transactions for testing, the auditor should consider those

representative of the activity and should include any important or unusual items

that are known. The number of transactions or actions selected for testing,

therefore, is less important than their representative character. (For reference,

illustrations of the steps to take in the review and testing of management control of

actual transactions are given in Chapter 3.)

REVIEW QUESTIONS

1. What does internal control mean to you as it relates to financial-statementexaminations?

2. Standards for internal accounting control have been developed and are readilyavailable. Can you contrast the status of management control standards withthose of internal control standards? What are the implications of this status for the activities of an organization?

3. What is meant by the following statements: Management control encompassesnot only internal control but also external control. Management control andinternal control are exactly the same when restricted to internal activitiespertaining to a financial-statement examination.

4. Do you. understand what management control is and can you list thecharacteristics of a good management control system?

5. Can you distinguish between a plan of organization for entities having manylevels both inside and outside of the entity and one for an organization havingseveral levels, all of which are within the entity?

6. What does the auditor normally do to get ready to prepare a flow chart?7. All organizations are operated by people. What types of questions are asked to

obtain the information concerning the jobs in an organization and the matchingof the people to the jobs?

8. How does the auditor usually find the stated policies of an organization?

9. What procedures are used for testing the nature, effectiveness, and theusefulness of management control? Do these procedures allow the auditor toidentify some evidence on all three elements of the audit objective?

10. The auditor should obtain adequate information as to the policies, procedures,and practices employed by management in accounting for its activities. Why isit important for an auditor to have a thorough understanding of the operationsand related procedures of the firm being audited?

11. Can hard and fast rules be established as to the amount or type of work to bedone in evaluating management control?

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