Information System Audit

How to Control the Digital Disruption

Philippe Peret

• Verlag: CRC Press
• Jahr: 2022
• ISBN:
  9781000610390
• Auflage: 1
• Thema: Business
• Thema: Auditing

The digitalization of companies is a recurrent topic of conversation for managers. Companies are forced to evolve at least as fast as their competitors. They have to review their organization, their processes, and their way of working. This also concerns auditors in terms of their audit strategy and working methods.

Digitalization is the tip of the iceberg that represents the increasing reliance on information technology of the company's information system. Companies have seen new competitors succeed with a digital approach, competitors that have opened new markets or new ways of interacting with their customers, and all business processes can be digitalized.

In this new paradigm, auditors have to renew themselves too. Long gone are the days of auditors specializing in one technique, like financial auditors or IT auditors. This makes it a phenomenal opportunity for auditing to renew itself, embracing the vision of the company's information system: long live the information system auditors!

This book proposes you to go step by step from a common understanding of our history of auditing to gradually defining and justifying the impacts of digitalization on the audit strategy and the preparation of audits.

Chapter 1Audit

DOI: 10.1201/9781003230137-1

If one knows the reasons why things are as they are, he can better foresee how they are likely to be in the years ahead.

John L. Carey, “History of Public Accounting” foreword from James Don Edwards

1.1 LEGACY

John L. Carey’s quote above summarizes the route used to understand the business of a company and assume or expect what it would be in the following years. The only piece missing in this smart sentence is about the understanding of the current technological trends and their impacts, for us the current information technology (IT) trends. Before focusing on IT trends and the need for an information system audit strategy, let’s all agree on our past, our audit past.

Information about commercial transactions has been recorded, annotated, controlled, and tracked since ancient times. Merchants record amounts, quantities, and types of products and with whom. They can find information they would otherwise have forgotten or check that a delivery corresponds to an order. Control has always been present, but it is the transformation of exchanges that brought the need to formalize the way of controlling. Products against products, then products against gold or silver (mainly), then products against bills of exchange, then exchanges of shares and bonds: Fairs have changed to become financial marketplaces.

Richard Brown goes back to 4500 BC to indicate that the Babylonian Empire was the first to have bookkeeping [RBR]. Since this period of bookkeeping, time has passed to arrive at the notion of accounting we refer to nowadays. The term accounting appeared in the 16th century and was defined in 1753 in the encyclopedia. The techniques of bookkeeping also evolved in parallel, with the first known book describing double entry bookkeeping by the Italian Lucas Pacioli in 1494. It was during the 19th century, as companies were structured differently with companies organized in different ways that accounting services appeared. The term bookkeeping was reduced to its technical aspect.

Even today, all this continues to change. The terms used by accounting standard bodies are significant. The International Accounting Standards Committee (IASC), established in 1973, was replaced by the International Financial Reporting Standards (IFRS) foundation with the International Accounting Standards Board in 2001. The focus shifts from International Accounting Standards (IAS) to International Financial Reporting Standards (IFRS). With this change, the emphasis is on the shift from an accounting view to a financial view of information in international accounting standard setting.

Auditing has had to adapt to these changes, on the one hand, to take into account changes in working methods and obligations of accountants, and, on the other hand, to extend its scope of information analysis, largely out of obligation, because of the computerization of all company processes. A company is the sum of these components and the internal and external interactions. We can’t separate finance from information system. Pure financial indicators are not enough, the auditor must analyze a company as an all and not in parts.

As in medicine a company cannot be reduced to 3 silos, finance, operations, and information system. This is why occidental medicine practice realized again that human nature cannot be reduced to the duality of Oromaze and Ahrimane, or matter and spirit. A purely physiological vision is not sufficient, Jo Marchant proposes as an example the research of Noakes:

The dogma was that athletes get tired when their bodies hit physical limits-their muscles run out of oxygen, fuel or become damaged by the accumulation of toxic byproducts such as lactic acid. This in turn triggers pain and fatigue, forcing us to stop exercising until we recover. Noakes proved that “In other words, fatigue isn’t a physical event, but a sensation or emotion, invented by the brain to prevent catastrophic harm.”

[JMA]

Audit must avoid this caveat. It has long been understood without misunderstanding as auditing finance or accounting. However, nowadays we are getting more and more familiar having the term used with other words such as with operational audit, quality audit, and social audit. Financial audit is now being used to differentiate it.

Audit is used so frequently, in so many different contexts, that defining it is an exercise in style. Its usage is so common that the temptation is great to analyze management practices since antiquity with our modern understanding of the word audit. To avoid this pitfall and to put things into perspective, it is necessary to note some remarkable points in the history of business and then to specify the context of the current use of the word audit. History will explain why audit used to be a financial audit as we now still think about it.

All this is mainly induced by Anglo-Saxon audit firms and large regional firms that apply equivalent working methods. The combined revenue of the largest audit firms, such as E&Y, PWC, KPMG, and Deloitte, increased steadily in the last decade, exceeding 157 billion U.S. dollars in 2020. This amount shows the importance of auditing for the proper functioning of financial markets. These firms work mainly with listed companies. These companies are required to have their accounts certified. This obligation is the result of an evolution of the financial regulations that govern the official stock exchanges, more particularly since the 19th century.

The use of the stock exchange as a trading place originated in the Netherlands. Some trace it to a Van der Beurse family from Bruges, because in the 13th century, traders met in their house. Others state it to be originating from the three purses carved above the door of the house that brought buyers and sellers together in Amsterdam, as purses as an object were used by traders at international fairs and marketplaces in Europe long before the Middle Ages.

The insurrection of Flanders against the House of Austria in 1488 made the commercial place of Bruges decline. The international trade then moved to Antwerp. Its trade was very dependent on its relations with the Spanish Empire. The war between the Spanish Empire and the North Sea provinces brought about the ruin of Antwerp. Businesses migrated from this place to Amsterdam. It was already flourishing because it had been a part of the Hanseatic League, before leaving it.

At that time, Lisbon was the only port that directly received products from India thanks to the traffic set up by the Portuguese and Amsterdam trade with Lisbon to supply products to northern and central European countries in particular. In 1580, Portugal came under Spanish rule and Philip II confiscated 50 Dutch ships.

Amsterdam was forced to review its strategy. It noticed the dependence of its trade with the Spanish Empire and thought about how to maintain its commercial activity on the products coming from India. Amsterdam was no longer thinking only of keeping the profits from trade with India, but also of increasing them. It cared little for the papal decision that divided the world and its discoveries between the Spanish and the Portuguese. She decided to follow the Portuguese example and go to India to trade with her own ships by direct routes. Amsterdam quickly became the center of world trade which did not yet include the American continent.

Its stock exchange allowed the development of all the wheels of commerce, with banks and insurance companies. Various scandals enameled the Amsterdam stock exchange like those of the East India Company or the tulip bulb bubble. The effects of the abuse of futures trading on the Amsterdam stock exchange are still fresh in our minds. These purchases were mainly for the shares of the East India Company. One buys and sells without having the goods, and one pays the difference up or down on the day of delivery of the ships.

The famous trade in tulip bulbs is of the same nature. From 1634 to 1637, all classes of the population engaged in what looked more like gambling. People speculated on the rise or fall of the price of tulip bulbs. People bid and paid large sums of money for bulbs that they did not have and did not plan to deliver. On the day of delivery, the flowers are not even delivered, and the price is not even paid, but just the difference.

In absolute terms, this is not different from what happens nowadays on the London International Financial Futures and Options Exchange (LIFFE) for Robusta coffee and the New York International Commodity Exchange (ICE) for Arabica coffee.

Trading in options (the option, not the obligation, to make or take delivery of a futures contract at a certain price threshold or expiration period) began in 1986 in New York. It has brought many speculators into the market, to the point that in 2015 the volume of contracts traded was 27 times that of world Arabica production.

[JMO]

Certainly, these speculations damaged the reputation of the Amsterdam Stock Exchange, but it was the decline of Holland’s maritime and commercial power that led to the decline of its stock exchange. The English statesman Oliver Cromwell promulgated a Navigation Act on October 9, 1651, which was one of the main triggers for this decline. This act favored the development of the English navy. It detailed the terms of international trade with England. Its expansion and the regulation on insurance, already published a few years before in 1600, led merchants to deal with increasingly large volumes.

The rise of the English maritime trade is, there also, encouraged by the Spaniards, as it had been the case with the Dutch. Philip II closes the port of Lisbon to the English, and thus indirectly forces them to go themselves in India to trade. The English navy becomes the most important and the most essential navy. It went to India by direct route and organized the recent discovery of the New World.

In the 16th century, Thomas Grasham, the richest merchant in London at the time, officially opened the first stock exchange in England, the Royal Exchange, in 1571. He had worked as an agent in Antwerp and knew its exchange well; he took it as a model. The location of the building is not insignificant, it is in the district of London where merchants already meet to negotiate the prices of products, but without having a particular place. They are not accepted at the Royal Exchange because of their manners, their education. The London Stock Exchange was then created in 1801 to consider the importance of world trade of the first maritime power of the time.

In the 16th century in France, things were also moving. At the end of the 16th century in particular, the operations that gave rise to successive government loans were important and justified the creation of eight security brokers, the ancestors of stockbrokers. They were increased to 30 by Louis XIII and an edict of 1638 ordered them to pool a quarter of the profits. This is the origin of the reserve fund.

At that time, there was already a kind of stock exchange in Paris. This word with the meaning of the meeting of financiers to sell and buy securities is in use since the reign of Henri III. The meeting was first held in the northern part of the Pont au Change downtown Paris (letter of Louis VII in 1141, confirmed by an order of Philippe le Bel in 1304), then moved to several places not far away. Under the Regency of the Duke of Orleans, the money changers moved to rue Quincampoix, in the vicinity of rue des Lombards, where foreign banks and a tradition of financial business had long existed. The ordinance of September 21, 1724, organized the Bourse (the Exchange), which moved to the eastern part of the Hôtel Mazarin, overlooking the rue Vivienne. It remained there until the Revolution, with discount offices, a cash office, a dividend office, and a stock office for duly authorized persons.

But why the need to create exchanges when exchanges were already taking place without them? The difference between these exchanges and the Italian Loggias of the 12th century or the English salons of the 16th century, for example, is that they are regular, regulated, and in controlled places.

Exchanges are places of exchange with regular days and hours of operation. It is much more convenient and interesting to sell or buy if there are more people involved, so knowing where and when to meet is necessary. To avoid having your goods stolen and to organize to bring them, the place must be well identified and protected.

In Paris, for example,

In the Quincampoix street, such a crowd was pressed that horses and carriages had to be banned and guards had to be placed at both ends of the street, drums and bell-ringers had to be placed there to warn, at 7 o’clock in the morning, of the opening of the operations and to clear the place at night. Never had such madness reigned, and it was with great difficulty that the entrance to the narrow alley was forbidden on Sundays and holidays.

[CST]

Given the inconveniences such as noise for the neighborhood or the risk of theft, exchanges were transferred to more and more enclosed and secured places. Thus, at the beginning of the 18th century, the rue Quincampoix was a vast free market in the middle of the street, anyone could come to buy or sell anything. This includes snuffboxes through canes and watches.

1.2 REGULATION, CONTROLS, AND AUDITS

The concerns of the authorities, whether in Paris, London, Chicago, or New York, have always been to designate a specific and fixed location, to the exclusion of all others, to serve as a framework for the trading of goods or securities. More particularly for stock market exchanges, which evolve and concern not so many goods as financial securities, the centralization of these exchanges in a single place is a necessary, but not sufficient condition for their sincerity and regularity.

The regulation of these marketplaces is the next step in the formalization of stock market exchanges. Apart from the fact that the marketplaces are covered, regulation is the main difference with the fairs and markets of the Middle Ages, which were used for exchanges until then. Exchanges on marketplaces and fairs are made on products that are physically present on the place of exchange. But for these products to be there, they must have undergone the vicissitudes of caravan journeys from the East to the West or the risks of the sea with ships in the Mediterranean Sea and then on the oceans. It is therefore tempting to sell loads of goods still in transit before their arrival (provided that the ship is still afloat). In the stock exchanges, we only trade on the values that represent them. Moreover, speculation on capital increases.

The regulation of the exchange market requires the establishment of regulations enforced by identified and authorized actors. To continue our example of the rue Quincampoix, the street, initially free to enter, was forbidden to “non-professionals,” such as artisans, wo...