In common, two major stages, simple comparisons and ration analysis, are used by auditors during analytical procedure; however ration analysis is a better understanding of the entity. Based on the data from question 6.33, the analysis procedure is allocated in two major stages. (textbook)
Simple comparison is to compare amounts between the 2009 financial statements and 2010 financial statements of Gourmet Pty Ltd.
The “net profit” increases from $56 240 000 in 2009 to $63 562 000 in 2010, the increasing amounts are up to $7 3220 000.
The “total shareholders equity” increases from $141 300 000 in 2009 to $204 862 000 in 2010, the increasing amounts are up to $63 562 000.
The performance of company is better from 2009 to 2010 in respect of above data, because company owns a steady and experienced management team; attempts to extend the range of products in order to enhance competition of industry and depends on appropriate strategy to acquire other smaller competitors. The simple comparison is a general analysis, however, auditor need to use ratio analysis in order to obtaining the specific data.
Based on 6.33, following ratios could be calculated for analysis.
The” current ratio” is 0.195 in 2009 and 0.280 in 2010. These two ratios are less than the better benchmark 2, even are lower than positive current ratio 1.5 as well.
The “quick asset ratio” is 0.070 in 2009 and 0.096 in 2010.
The “gross profit ratio” is 0.481 in 2009 and 0.463 in 2010.
The “net profit ratio” is 0.183 in 2009 and 0.193 in 2010.
The “debt to equity ration” is
(a) ‘The inherent risk is the susceptibility of an account balance, class of transactions or disclosure to material misstatement given inherent and environmental characteristics, but without regard to internal control.’ (textbook) Based on the background information from 6.33, following factors could impact the inherent risk:
A new finance director has joined in the company. The change of important management position would increase inherent risk. At the same time, the new finance director will face pressure to outperform pervious result; the pressure could provide an incentive for him or her to involve the misstatement and fraud of financial report. Also the inherent risk would increase.
The company owned 25 outlets of varying sizes and geographic locations, which would increase inherent risk, because it is hard to be controlled by managers of entity.
Company has signed contract regarding the construction and development of a restaurant and entertainment complex, which would increase inherent risk due to the lack of expertise about the new market.
The company installed a new computer system; the change of information technology may not work as expected or may be unreliable and could affect the accuracy of financial report. Therefore, the inherent risk would be increased.
(b)(i) Based on the audit risk model, three components consist of audit risk: inherent risk, control risk and detection risk. The increase of inherent risk will result in that misstatements likely to occur in company’s financial report, which would lead to the increase of audit risk as well.(textbook)
(c) The level of materiality should be considered as a key point to plan the nature, timing and extent of audit procedure, and the relationship between audit risk and materiality is inverse. (textbook)Therefore, the amount of preliminary materiality level reduced from $5000000 to $3200000 after review of inherent risk, because that the inherent risk is higher than the auditor’s anticipation. Thus, auditor should increase the extent of audit procedures, selecting a more effective audit procedure and performing audit procedures closer to the balance date, particularly in respect to account is considered importantly by auditors.(text book)
(a) The objectives of internal auditors are that ‘Internal auditing is an independent, objective assurance and consulting activity designed to add value and improve an organisation’s operations.’ (Adam Cunningham). ‘The internal auditor’s scope of work is comprehensive. It serves the organization by helping it accomplish its objectives, and improving operations, risk management, internal controls, and governance processes.’
External auditor is to verify that the annual accounts provide a true and fair picture of the organisation’s finances; and that the use of funds is in accordance with the aims and objects as outlined in the constitution.
The scope of external auditors
(b) External auditor can adopt the information from internal auditor included that:
The internal audit function as a part of the internal control, will impact the external auditor’s assessment of control risk and the scope of audit procedures.
The descriptions and other documentation of internal control will contribute the external auditor to gain an understanding of the company’s internal control.
The direct assistance by internal auditor will help external auditor to make substantive test or tests of controls(textbook)
(c) Along with internal auditor involved in assessing the company strategy and identifying the associated risks, which will provide helps for the external auditor regarding to undertake a business risk approach to the audit. In addition, internal auditors should hold adequate skills, knowledge, experience, integrity and objectivity to ensure the effective information for external auditor. (textbook) Based on the information on 8.34, Gourmet Pty Ltd owns an experienced and professional internal auditing team. However, the external auditor should consider carefully for these information, because that “the objectives of the internal auditor should be the same as the objectives of the company” (David A. Wood).Therefore, external auditor must select information under the requirement of independent audit.
(d) The objective 1, objective 2 and objective 4 are related to ensure the effective operation and acquirement of maximal benefit for company, which are not included in control activities. The control activities is that ‘policy and procedures that pertain to performance reviews, information processing, physical controls and segregation of duties’. (Textbook) Therefore, the objective 3, objective 5 and objective 6 are related to internal control activities, which are need to be relevant to external auditor.
(a) The related internal control must be identified effectiveness if auditors plan to rely on this control. Therefore, auditors need to set out tests of control to confirm effectiveness of controls. From this case, the audit partner has decided to use the work of the internal audit group (LAG). One of the work papers from LAG is to examine payments made to creditors throughout the year and determine whether the procedures laid down in the Accounting Manual have been properly followed. On the other word, this paper is related to the tests of control about payment. The result of this test indicates some errors:
(i) Payments that were not matched to an approved purchase order, however, all other documentation was attached.
The objective of this is to test the occurrence of purchases of inventory transaction. This error implies that related transaction may not occur or the transaction is unauthorised.
(ii) Payments that were not made to an approved supplier.
The objective of this is to test the occurrence of purchases of inventory transaction. This error implies that related transaction may not occur or the transaction is unauthorised.
(iii) Payments that were authorized by a second party, although this was not required.
The notes explain that new financial accountant being unaware of firm policy. Although it has been remedied, the related transactions may do not occur or is unauthorised.
(iv) Payments that had no supporting documentation attached.
The objective of this is to test the occurrence of cash disbursements transactions. This error implies that related transaction may not occur or the transaction is unauthorised or the goods or services may not receive.
(v) Payments that did not bear evidence that computation on creditors’ invoices had been checked.
The objective of this is to test the accuracy of purchases of inventory transactions. The error implies that related transactions are not recorded correctly.
Also, these errors indicate that the internal control regarding payments is not very effective, because the proportion of error is almost 28% of 60 samples. It means that the risk of this related internal control is higher than average level.
(b) Under this situation, external auditors should consider whether the evidences adopted by internal auditors are satisfied sufficiency and appropriateness. Particularly in respect of the appropriateness should be discussed here. Gourmet Pty Ltd is a large private company; therefore it must have a large volume of transactions. If internal auditors only selected 60 samples, it should be considered by external auditors that the amounts of samples are not sufficient and the control risk is higher than its actual level. Therefore, they can choose to increase the extent of test of control to try to reduce the risk level to an acceptable level. If the control is still not working as they expected, they can choose increase the extent of substantive testing in order to continual reliance on this control. If the control risk still can not be reduced by these tests of control, external auditors will give up the reliance on the control. In effect, auditors have determined that control does not exist or the existence of control can not provide reliable evidence. (textbook)
Controllability Principle in Responsibility Accounting
One underlying concept of the traditional management control system is the responsibility accounting. It is viewed as an important feature because it permits the ease of decentralization in M-form organizations. It distributes accountability and provides accounting reports on these distributed accountabilities. It provides a way for large unmanageable organizations to be managed such that all subsystems have similar goals. It can be defined as a system where managers are held responsible for activities under their leadership. Built on responsibility accounting is the principle of controllability. This principle has been viewed as the cornerstone of responsibility accounting (S. Modell and A. Lee, 2001). The principle states that managers should only be evaluated on elements that are within their control. Research literatures on responsibility accounting point to the fact that responsibility accounting and the controllability principle cannot be made independent of one another. The relationship becomes obvious when both are looked at together; responsibility accounting holds the manager responsible for a particular division but the controllability principle ensures that the managers are held responsible only for factors that they can control. For this reason, Ferrara (1964) called responsibility accounting a communication system with the sole purpose of helping the organization achieve its goals. The controllability principle, therefore, serves to make this communication channel clearer and understandable. The role played by the controllability principle makes it an appealing notion. However, much research articles have argued for the observance of controllability principle as well as against its observance in responsibility accounting. This paper seeks to evaluate the arguments for and against the observance of the principle of controllability.
Arguments For and Against the Observance of Controllability Principle Recent research concludes that there are two types of uncontrollable factors within the borders of controllability; internal uncontrollable and external uncontrollable factors. Studies also show that when it comes to controllability, managers consider responsibility accounting fair when the effects of internal uncontrollable factors on their performance is negated in appraisal. The concept of fairness was given in McNally G. (1980) as one of the rationales for observing the principle of controllability. He stated this using the expectancy theory of motivation. The notion of fairness makes the observance of controllability desirable when performance evaluations are carried out on the managers. The controllability principle makes the appraisal a fair one. This is as a result of the appraisal done in consideration of the controllable factors and uncontrollable factors. The result of the appraisal would be a satisfied and possibly motivated manager. Choudhury N. (1986) goes further to say that this conforms to the commonly held principle of justice. The equity theory of motivation also helps to explain it further the theory says a fair day’s work for a fair day’s pay. In the case of the manager and controllability, this would be a fair assessment for a fair period’s work. Achieving organizational goals are very important for any firm and the means of doing that is through the managers of the decentralized firms but if the manager’s perception of the performance appraisal is unfair, he is demotivated and unsatisfied. He also loses focus and possibly direction. Going by McGregor’s Y theory of motivation, this could damage the manager’s perception of his work. He wants to work and put in his best but if his best is judged against things out of his control, this could lead him to learned helplessness or to leave the firm (Nandan C, 1986). For such an organization whose appraisal system is deemed to be unfair, they would have a high turnover rate. The implications of this are far reaching as harmful managerial behaviour might crop up.
With fairness in place, observing the principle of controllability helps managers to pay attention to uncontrollable factors. The responsibility accounting holds them accountable for what goes on in their divisions; controllability principle makes the uncontrollable factors obvious. Managers will direct corrective efforts to these uncontrollable factors (McNally G., 1980). This in turn would help to influence the manager’s behaviour such that it aligns with organizational goals. The knowledge that his appraisal is a fair one would motivate him to try to exert some influence over these uncontrollable factors. If the influence pays off, then he is one step closer to achieving organizational goals. This also induces him/her to pay more attention to factors previously perceived as uncontrollable but now “influenceable” because of the effort he has applied (F. Giraud, P. Langevin and C. Mendoza, 2008). In the agency theory framework of management control where all information is used to appraise the manager’s performance in line with the controllability principle, the appraisal report highlights the controllable and uncontrollable factors. Senior management can attach rewards to these seemingly uncontrollable factors to ensure that managers do their best to attain them without neglecting other duties necessary for the organizational goal attainment. S. Modell and A. Lee (2001) refer to the influence over seemingly uncontrollable factors when they noted that reliance on controllability principle helps to enhance managerial control of powerful institutional actors such as managers. The empirical study carried out by Frow N, Marginson D, and Odgen S. (2005) at Astoria PLC also points out the fact that factors that cannot be controlled can be influenced with some effort; they found out that the firm uses the AIP (Astoria Improvement Process) to reinforce influenceablity. They noted that the AIP helps the manager retain some form of control where they have only partial controllability but the AIP also imposes expectation on the managers. This would ensure that the managers make extra effort to influence these factors to meet the expectation laid up on them.
Controllability principle helps to neutralize the effects of uncontrollable factors on a manager’s performance, thus giving a true picture of the manager’s efforts. This is another appealing notion of the controllability principle. It has been argued that the organization is a social system that grows in complexity like the biological systems. This complexity brings with it constant changes and in the organizational context, this would mean unforeseen changes that can have positive or negative effects on the efforts of the manager. One of such complexity is the competitive and economic elements. Both of these can affect the manager’s effort in a positive or negative way. An appropriate example is the financial crisis of 2007-2010 which has caused a downturn in stock prices. This in turn affects the profit and investment levels but the controllability principle neutralizes the effects of the financial crisis on the manager’s performance. Giraud et al (2008) noted that neutralization of uncontrollable factors can take two forms; “ex-ante neutralization” and “ex-post neutralization”, both of which have the same the same result, neutralizing the effects of uncontrollable factors on the performance of the managers.
The Controllability principle provides a reliable assessment of the manager’s performance. When all uncontrollable factors have been neutralized, the assessment will be based on the efforts of the manager in improving the division under his control. Choudhury (1986) notes this when he says that the results of the division under the manger’s control is a combination of the manager’s efforts and the uncontrollable factors. Separating manager’s effort from uncontrollable factors provides a better basis for assessment. In the principal agent framework, this would be a very necessary basis for rewards, the principal uses everything in his disposal to appraise the manager but when controllability principle removes the uncontrollable factors, the manager’s efforts are clearly seen. The rewards can then be based on the manager’s efforts at controlling the factors that he could to achieve organizational objectives.
Ferrara (1964) argues that the controllability principle in responsibility accounting helps the organization to grow in that it helps to locate the errors and mistakes of the organizational members. He argues that ‘errors and mistakes are the stuff of which progress is made ‘. He also argues that controllability is a means of locating those activities and people in the organization in need of help so that assistance can be rendered and scarce resources of the organization would be more utilized. This would mean that controllability principle works in line with the organizational goals and where a positive attitude about it is inculcated in managers, the organization should move at the targeted pace. The responsibility accounting reports will make clear the controllable factors and the uncontrollable factors but amidst the controllable factors, a well prepared report will reveal where there might be problems. These problems can be considered and worked on or used as a base for future strategic plans. When all errors and mistakes are corrected, they make room for improvement.
In spite of these appealing advantages for controllability principle, there have been arguments against its observance in the responsibility accounting. Choudhury (1986) argues that controllability principle is not ‘sacrosanct’. Considering the size of big firms, a lot of factors hinder the practicality of the controllability principle. The interdependencies of the divisions within these firms create an unclear line with respect to divisional boundaries and places difficulty on the responsibility accounting process. One such factor is the task complexity of some divisions. If a particular manager works with another divisional manager to accomplish a difficult task, it becomes difficult to appraise the manager’s efforts because supposedly, the manager with the task had control over the particular task but performance appraisal with controllability principle makes this difficult. The manager had the task under his control but the other manager that helped had no control over the task but had ideas and participated in accomplishing the task. In this aspect Amey (1979) compares organizations to biological systems that grow in complexity. The complex growth makes controllability impossible.
Observing the controllability principle in complex organizations is limiting on the innovativeness and the creativity of managers in the organizations. When managers are aware that they are being assessed on controllable factors, they would not be willing to take on risky ventures that have potential benefits for the organization. In their examination of the limitations of controllability principle, Antle and Demski (1988) conclude that the limitations of controllability on organizational growth can be modified through the information content notion. The limitation of the controllability principle is a hindrance on the positive results of team work. M-form organizations require team work to succeed, however, the observance of the controllability principle in the principal-agent framework breeds competition and this affect team work negatively thus a sales manager might have a good idea on how to achieve the tasks of the marketing manager but because he does not want the marketing manager to do better that him in their performance appraisal, he would not assist or offer advice. Team work is therefore placed at the bottom of the list of useful organizational ethics. On the contrary where both managers would work together without neglecting their divisional duties, they could achieve desired results and if possible, meet their separate targets. The study carried out by Frow et al (2006) supports this fact; their findings revolve around accountability without controllability and the results also shows that the Astoria Plc. encouraged more co-operations because of organizational promotion of greater interdependencies. Another aspect where the observance of controllability principle is limiting is the area of performance evaluation. It limits the use of market measures in evaluating the manager’s performance. The use of market measures is one of the ways of evaluating senior management employees and the limiting effect of the controllability principle weakens the effectiveness of these measures (Merchant, 2006).
The limitations of the controllability principle lead to rigidity in organizations. The controllability principle does not allow room for organizational flexibility. It limits the organization to growth based on only controllable factors. Modern day organizations are very dynamic and this constant change is not compatible with the concept of controllability. If controllability principle is been observed in an organization, the organization would not allow change such that it is flexible and easily adaptable to changes in its environment. Amey (1979) argued that businesses needed to maintain flexibility in ‘internal arrangements’ such that adjustment would not be impeded and its links with its environment would grow stronger.
Observing controllability principle in responsibility accounting involves some elements of subjectivity. This occurs when the basis for establishing controllable and uncontrollable factor are unclear. The performance evaluation team will have to set a criterion to use when carrying out an appraisal; this criterion would be based on what they think and probably not what they are aware of. In doing this, they become subjective in the appraisal. This would be perceived by the manager as unfair appraisal. He would view himself as being unfairly treated without consideration of factors contingent upon his performance. As a result of this perception of the performance appraisal, the manager could behave in a dysfunctional way. Such actions would be detrimental to the organizational goals. A manager who perceives an unfair system would also be demotivated. The findings of the research done by Giraud et al (2008) concluded that managers do not want uncontrollable external factors neutralized because of the level of subjectivity involved in it. Similarly, drawing from the study carried out by Modell and Lee (2001) institutional factors affect the controllability principle, in turn these factors affect the efficiency of the responsibility accounting system.
The controllability principle is also expensive to maintain in an organization. I would argue that the process involved in ensuring the observance of responsibility principle is not cost efficient. The process would require constant research into the market forces so as to distinguish controllable factors from uncontrollable factors; where it is not possible to make such a distinction, the organization would have to incur more costs to ensure that the performance appraisal system is perceived as fair by its managers. The energies and costs that would be consumed by such a process would be effectively used in another part of the organization where it would be beneficial. Giraud et al (2008) also argues on the difficulty of evaluating uncontrollable factors, they specifically note the difficulty as regards the impact of economic recession. Thus, I would also argue that payment for the services of qualified experts on the distinction between controllable and uncontrollable factors for performance evaluation is an unnecessary cost to the organization.
Research has also shown that observing the controllability principle leads to dysfunctional behaviour of managers. Hirst (1983) noted that reliance on performance measures that capture uncontrollable factors promote dysfunctional behaviour. This as a result of the manager’s perception of the performance evaluation system; he wants to avoid the effects of uncontrollable factors and he does that by engaging in activities that do not promote organizational objectives. Giraud et al (2008) mention such activities to include data manipulation, creating slack and developing an ‘excuse culture’. He narrows his focus to just the factors that he knows he would be appraised by and where he fails, his self-efficacy is reduced. Observing controllability principle in responsibility accounting can have consequences for organizational goals. It can lead to short termism on the part of manager. In narrowing their focus, managers focus on the components of the performance evaluation system and not on the organizational goals. This would lead to the neglecting of organizational long term goals. Thus, a manager with a long term goal of improved return on investment but with a sales division short term goal of number of user complaints per month and percentage variation from budgets will focus only on reducing the percentage variation from budgets thereby maligning the chances of improving the ROI. This might mean inferior sales strategies that would result in a drop in sales figures which have negative effects on the ROI.
Conclusion Theoretically, observing the controllability principle in responsibility accounting has been perceived to have its advantages and disadvantages to the organization. The definition of the controllability principle indicates that there is a clear distinction between controllable and uncontrollable factors. This distinction supposedly makes it easy to observe in responsibility accounting. However, empirical studies reveal that organizations do not fully observe the controllability principle. Findings indicate that there is some sort of continuum that has controllable factors on one end and uncontrollable factors on the other end with varying degrees of control in between. Studies also show that some managers do not see themselves on either end of the continuum but somewhere in the middle. This means that strict observance of the controllability principle is impractical. Choudhury (1986) argues that the responsibility accounting concept should not be hindered by controllability and that it should be interpreted independently of controllability. Moreover, controllability should be defined contingent upon the contexts of the organization. McNally (1980) also argues that controllability can be applied in a modified version. Recent literature also indicates that organizations tend to hold managers for factors that they can influence rather than factors that they can control. This lies somewhere between controllable factors and uncontrollable factors on the controllability continuum. Giraud et al (2008) refer to this as the ‘influencable’ factors. In addition, the interdependencies of organizations blur the lines separating controllability and other sub-systems in the responsibility accounting system (Hirst, 1983) as well as the uncertainties of the organizational environment.
Consequently, I would argue that strict observance of the controllability principle is unrealistic. The modification and the re-definition of the controllability principle is a gradual shift away from the premise of the controllability principle. The difference between controllable and uncontrollable factors is lacking in clarity as regards modern organizations. It also does not align well with the structure of modern day organizations. Similarly, factors that can be influenced today might not be influenced the next day or next operating period because of the unpredictability of the environments of the organizations. Besides, can the ability to influence an event be measured and to what extent can it be measured?