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7.5 During a recent review, ABC Corporation discovered that it has a serious internal
control problem. It is estimated that the impact associated with this problem is $1
million and that the likelihood is currently 5%. Two internal control procedures have
been proposed to deal with this problem. Procedure A would cost $25,000 and reduce
likelihood to 2%; procedure B would cost $30,000 and reduce likelihood to 1%. If
both procedures were implemented, likelihood would be reduced to 0.1%.
a. What is the estimated expected loss associated with ABC Corporation’s internal
control problem before any new internal control procedures are implemented?
Expected Loss = Risk * Exposure = 0.05 * $1,000,000 = $50,000
b. Compute the revised estimate of expected loss if procedure A were implemented,
if procedure B were implemented, and if both procedures were implemented.
Control
Procedure
Risk
Exposure
Revised
Expected
Loss
Reduction in
Expected Loss
Cost of
Control(s)
Net
Benefit
(Cost)
A
0.02
$1,000,000
$20,000
$30,000
$25,000
$ 5,000
B
0.01
$1,000,000
$10,000
$40,000
$30,000
$10,000
Both
0.001
$1,000,000
$ 1,000
$49,000
$55,000
$(6,000)
c. Compare the estimated costs and benefits of procedure A, procedure B, and both
procedures combined. If you consider only the estimates of cost and benefit, which
procedure(s) should be implemented?
d. What other factors might be relevant to the decision
Another important factor to consider is how critical the $1,000,000 loss would be to
ABC Corporation.
Control Procedure A - Goal Seek-setup.
Control Procedure A - Goal Seek - solved.
7.6 The management at Covington, Inc., recognizes that a well-designed internal control
system provides many benefits. Among the benefits are reliable financial records that
facilitate decision making and a greater probability of preventing or detecting errors
and fraud. Covington’s internal auditing department periodically reviews the
company’s accounting records to determine the effectiveness of internal controls. In
its latest review, the internal audit staff found the following eight conditions:
1. Daily bank deposits do not always correspond with cash receipts.
2. Bad debt write-offs are prepared and approved by the same employee.
3. There are occasional discrepancies between physical inventory counts and
perpetual inventory records.
4. Alterations have been made to physical inventory counts and to perpetual
inventory records.
5. There are many customer refunds and credits.
6. Many original documents are missing or lost. However, there are substitute
copies of all missing originals.
7. An unexplained decrease in the gross profit percentage has occurred.
8. Many documents are not approved.
For each of the eight conditions detected by the Covington internal audit staff:
a. Describe a possible cause of the condition.
b. Recommend actions to be taken and/or controls to be implemented that would
correct the condition. Adapted from the CMA Examination
#
a. Possible Cause
b. Recommendation to Correct Condition
1
Daily bank deposits do not always
correspond with cash receipts.
Timing difference between when cash is
received and when deposited in the bank
- Cash is received after the day’s bank
deposit is prepared and sent to the bank.
- Bank credits bank deposits received after a
certain hour on the next day.
Cash receipts are being stolen
Make two deposits for each day’s receipts.
An employee who does not handle cash receipts
daily reconciles each day’s cash receipts per book
with deposits per bank
List cash received each day; compare it to daily
cash deposits.
Have 2 people involved in cash receipts if practical.
If only one can be involved, video tape the receipts
process.
Have an employee who does not handle receipts do
all reconciliations.
2
Bad debt write-offs are prepared and
approved by the same employee.
Collusion between customers and the
employee writing off the bad debts.
Require all bad debt write-offs to be approved by a
second employee.
3
Occasional discrepancies between physical
inventory counts and perpetual inventory
records.
Unauthorized access to physical inventory
and/or inventory records.
Inventory theft by employees
Limit physical and logical access to the inventory
records to authorized employees.
Require that all adjustments to inventory records be
approved by a responsible official.
Count all inventory when received at the warehouse
and at the storeroom; reconcile the counts.
Count inventory to be shipped before it is removed
from the storeroom, when received by shipping, and
when shipped; reconcile counts.
4
Alterations to physical inventory
counts and perpetual inventory
records
Unauthorized access to inventory records.
Fraud
Limit physical and logical access to the inventory
records to authorized employees.
Require that all adjustments to inventory records be
approved by a responsible official.
Examine physical inventory counts and perpetual
inventory records for evidence of fraud
Terminate any employees that commit fraud
5
Many customer refunds and credits.
Collusion among customers, salespersons,
common carriers, and the shipping and
accounting departments of Covington.
Poor product quality
Segregate duties so refunds and credits are
authorized by responsible employees not otherwise
involved in sales, shipping, or maintaining accounts
receivable.
Fix production problems
6
Many original documents are missing
or lost. However, there are substitute
copies of all missing originals.
Failure to use pre-numbered documents.
Fraud was perpetrated, original copies of the
documents were destroyed, and they were
replaced by photocopies.
Use pre-numbered documents to facilitate the
control and identification of documents.
Investigate all instances where originals are missing
and photocopies are used.
7
An unexplained decrease in the gross
profit percentage has occurred.
Granting unauthorized discounts or credits to
customers.
Theft of inventory
Require the approval of a responsible party before
granting customer discounts or credits.
Count all inventory when received at the warehouse
Customers given lower, preferential sales
prices
Unrecorded sales
Hold storeroom employees responsible for all
inventory losses.
Require the approval of a responsible party before
granting preferential sales prices
Require the use of pre-numbered sales documents
and do not allow inventory to leave the warehouse
without an accompanying sales document.
8
Many documents are not approved.
Lack of, misunderstanding of, or failure to
comply with written procedures.
Fraud committed by bypassing the approval
process
Prepare or update written procedures and train
employees using the procedures
Hold employees responsible for not approving
documents
Examine unapproved documents for evidence of
fraud
Terminate any employees that commit fraud
7.7 Consider the following two situations:
For the situations presented, describe the recommendations the internal auditors
should make to prevent the following problems. Adapted from the CMA Examination
Situation 1: Many employees of a firm that manufactures small tools pocket some of
the tools for their personal use. Since the quantities taken by any one employee are
immaterial, the individual employees do not consider the act as fraudulent or
detrimental to the company. The company is now large enough to hire an internal
auditor. One of the first things she did was to compare the gross profit rates for
industrial tools to the gross profit for personal tools. Noting a significant difference,
she investigated and uncovered the employee theft.
Situation 2: A manufacturing firm’s controller created a fake subsidiary. He then
ordered goods from the firm’s suppliers, told them to ship the goods to a warehouse
he rented, and approved the vendor invoices for payment when they arrived. The
controller later sold the diverted inventory items, and the proceeds were deposited to
the controller’s personal bank account. Auditors suspected something was wrong
when they could not find any entries regarding this fake subsidiary office in the
property, plant, and equipment ledgers or a title or lease for the office in the real-
estate records of the firm
7.8 Tralor Corporation manufactures and sells several different lines of small electric
components. Its internal audit department completed an audit of its expenditure
processes. Part of the audit involved a review of the internal accounting controls for
payables, including the controls over the authorization of transactions, accounting for
transactions, and the protection of assets. The auditors noted the following items:
1. Routine purchases are initiated by inventory control notifying the purchasing
department of the need to buy goods. The purchasing department fills out a
prenumbered purchase order and gets it approved by the purchasing manager.
The original of the five-part purchase order goes to the vendor. The other four
copies are for purchasing, the user department, receiving for use as a receiving
report, and accounts payable.
2. For efficiency and effectiveness, purchases of specialized goods and services are
negotiated directly between the user department and the vendor. Company
procedures require that the user department and the purchasing department
approve invoices for any specialized goods and services before making payment.
3. Accounts payable maintains a list of employees who have purchase order approval
authority. The list was updated two years ago and is seldom used by accounts
payable clerks.
4. Prenumbered vendor invoices are recorded in an invoice register that indicates the
receipt date, whether it is a special order, when a special order is sent to the
requesting department for approval, and when it is returned. A review of the
register indicated that there were seven open invoices for special purchases, which
had been forwarded to operating departments for approval over 30 days
previously and had not yet been returned.
5. Prior to making entries in accounting records, the accounts payable clerk checks
the mathematical accuracy of the transaction, makes sure that all transactions are
properly documented (the purchase order matches the signed receiving report and
the vendor’s invoice), and obtains departmental approval for special purchase
invoices.
6. All approved invoices are filed alphabetically. Invoices are paid on the 5th and
20th of each month, and all cash discounts are taken regardless of the terms.
7. The treasurer signs the checks and cancels the supporting documents. An original
document is required for a payment to be processed.
8. Prenumbered blank checks are kept in a locked safe accessible only to the cash
disbursements department. Other documents and records maintained by the
accounts payable section are readily accessible to all persons assigned to the
section and to others in the accounting function.
Review the eight items listed and decide whether they represent an internal control
strength or weakness
a. For each internal control strength you identified, explain how the procedure
helps achieve good authorization, accounting, or asset protection control.
b. For each internal control weakness you identified, explain why it is a weakness
and recommend a way to correct the weakness
Adapted from the CMA Examination
#
a. Why it is a strength
b. Why it is a weakness
b. Recommendation to
correct weakness
1
User authorization means the
right materials and quantities
will be ordered.
The use of pre-numbered
purchase orders allows all POs
to be accounted for.
A purchase order copy should not be used
as a receiving report unless the quantities
have been blanked out.
The receiving report is prepared
after an independent count and
identification.
2
The user/purchaser may not be trained in
purchasing techniques and could be
overcharged in the transaction.
Both the user and the
purchasing agent should be
involved in negotiating with the
company.
2
It increases the potential for collusive
agreements.
The purchasing department
should approve orders before
the purchase, not before
payment is made.
3
Failure to properly maintain the list of
authorized signatories renders it useless
Update the list as soon as a
change in purchase
authorization occurs.
Payables clerk should be
required to use the list.
4
Numbering and recording
process establishes good
control over invoices and helps
ensure their recording in
accounting records.
Failure to follow-up on open invoices
indicates an ineffective control due to a
lack of follow-up.
A periodic review and follow-
up of all open items.
5
The transaction audit helps
minimize errors and helps
ensure that only properly
authorized transactions are
recorded.
6
Paying monthly on only the 5th or 20th
prevents payment of any invoice due on
another date.
Approved, unpaid invoices
should be filed by payment due
date first, and then
alphabetically.
6
Taking unearned cash discounts causes
additional paperwork when disputed by
suppliers and creates animosity. This
policy may lead to fewer discounts being
offered.
Pay suppliers on or before the
discount date.
Lost discounts should be
analyzed for cause and future
avoidance.
7
Proper separation of duties
exists
Requiring original documents
and cancelling them after
payment reduces duplicate
payments.
8
Proper protection of blank
checks (locked safe only
accessible to cash
disbursements department
Unlimited access to cash disbursement
documents (other than blank checks)
permits unauthorized alteration of
payables documents. This could result in
a loss of control, a loss of accountability,
or a loss of assets - as well as improper or
inaccurate accounting or destruction of
records.
A policy limiting access to and
physical protection of accounts
payable documents and records
should be established and
monitored.
7.7 Lancaster Company makes electrical parts for contractors and home improvement
retail stores. After their annual audit, Lancaster’s auditors commented on the
following items regarding internal controls over equipment:
1. The operations department that needs the equipment normally initiates a
purchase requisition for equipment. The operations department supervisor
discusses the proposed purchase with the plant manager. If there are sufficient
funds in the requesting department’s equipment budget, a purchase requisition is
submitted to the purchasing department once the plant manager is satisfied that
the request is reasonable.
2. When the purchasing department receives either an inventory or an equipment
purchase requisition, the purchasing agent selects an appropriate supplier and
sends them a purchase order.
3. When equipment arrives, the user department installs it. The property, plant, and
equipment control accounts are supported by schedules organized by year of
acquisition. The schedules are used to record depreciation using standard rates,
depreciation methods, and salvage values for each type of fixed asset. These rates,
methods, and salvage values were set 10 years ago during the company’s initial
year of operation.
4. When equipment is retired, the plant manager notifies the accounting department
so the appropriate accounting entries can be made.
5. There has been no reconciliation since the company began operations between the
accounting records and the equipment on hand.
Identify the internal control weaknesses in Lancaster’s system, and recommend ways
to correct them. Adapted from the CMA Examination
Weakness
Recommendation
1. No authorization form describing the
item to be acquired, why it is needed,
expected costs, and benefits.
2. Equipment purchases over a certain
amount are not reviewed and approved
by top management.
The purchase requisition should include an item
description, why the item is needed, estimated costs and
benefits, account code, useful life, depreciation method,
and management approval.
Large sums of money can be spent on equipment. Large
purchases should be approved by top management
3. Purchase requisitions for fixed assets
are intermingled with requisitions for
inventory, even though they are very
different purchases. This results in a
lack of control over the much more
Authorized equipment acquisitions should be processed
using special procedures and purchase orders.
Copies of equipment purchase orders should be distributed
to all appropriate departments so they can be monitored.
expensive equipment acquisitions.
4. No mention of pre-numbered purchase
requisitions or purchase orders.
Pre-numbered purchase requisitions and purchase orders
should be used so that all documents can be accounted for.
5. Plant engineering is not inspecting
machinery and equipment upon
receipt.
6. Equipment is not tagged and
controlled to prevent theft.
7. Plant engineering is not helping with
the equipment installations.
8. Machinery and equipment accounting
policies, including depreciation, have
not been updated to make certain that
the most desirable methods are being
used.
Machinery and equipment should be subject to normal
receiving routines. In addition, plant engineering should
inspect the machines to make certain the correct item was
delivered and that it was not damaged in transit.
All new machinery and equipment should be assigned a
control number and tagged at the time of receipt.
Plant engineering should help with the equipment
installations to ensure expensive equipment is not
damaged.
Machinery and equipment accounting procedures,
including depreciation, must be updated periodically to
reflect actual experience, changes in accounting
pronouncements, and income tax legislation.
9. Equipment retirement schedules are
not reconciled periodically to general
ledger control accounts.
Equipment retirement schedules, which provide
information on asset cost and accumulated depreciation,
should be reconciled to general ledger control accounts at
least yearly.
Periodically, a physical inventory of fixed assets should be
taken and reconciled to the equipment retirement schedule
and the general ledger control account.
