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7.10 The Langston Recreational Company (LRC) manufactures ice skates for racing,
figure skating, and hockey. The company is located in Kearns, Utah, so it can be close to
the Olympic Ice Shield, where many Olympic speed skaters train.
Given the precision required to make skates, tracking manufacturing costs is very
important to management so it can price the skates appropriately. To capture and
collect manufacturing costs, the company acquired an automated cost accounting
system from a national vendor. The vendor provides support, maintenance, and
data and program backup service for LRC’s system.
LRC operates one shift, five days a week. All manufacturing data are collected and
recorded by Saturday evening so that the prior week’s production data can be
processed. One of management’s primary concerns is how the actual manufacturing
process costs compare with planned or standard manufacturing process costs. As a
result, the cost accounting system produces a report that compares actual costs with
standards costs and provides the difference, or variance. Management focuses on
significant variances as one means of controlling the manufacturing processes and
calculating bonuses.
Occasionally, errors occur in processing a week’s production cost data, which
requires the entire week’s cost data to be reprocessed at a cost of $34,500. The
current risk of error without any control procedures is 8%. LRC’s management is
currently considering a set of cost accounting control procedures that is estimated to
reduce the risk of the data errors from 8% to 3%. This data validation control
procedure is projected to cost $1,000 per week.
a. Perform a cost/benefit analysis of the data-validation control procedures.
Without
Control
Process
With
Control
Process
Net
Difference
Expected
Cost of Production Data Reprocessing
$34,500
$34,500
Risk of Data
Errors
8%
3%
Expected Reprocessing Costs
$2,760
$1,035
$1,725
(Cost of Process * Risk)
Cost of Control Process
$1,000
-$1,000
Net estimated
benefit/(loss)
$725
b. Based on your analysis, make a recommendation to management regarding the
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control procedure.
a. The current risk of data errors without any control procedures is estimated to be
8%. The data control validation procedure costs $1,000 and reduces the risk to
3%. At some point between 8% and 3% is a point of indifference—that is, Cost of
reprocessing the data without controls = Cost of processing the data with the
controls + Cost of controls. Use a spreadsheet application such as Excel Goal Seek
to find the solution
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Without
Control
Process
With
Control
Process
Net
Difference
Expected
Cost of Production Data Reprocessing
$34,500
$34,500
Risk of Data Errors
6%
3%
Expected Reprocessing Costs
$2,035
$1,035
$1,000
(Cost of Process * Risk)
Cost of Control Process
$1,000
-$1,000
Net estimated benefit
$0
Goal Seek Setup:
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Goal Seek Solved:
7.11 Spring Water Spa Company is a 15-store chain in the Midwest that sells hot tubs,
supplies, and accessories. Each store has a full-time, salaried manager and an
assistant manager. The sales personnel are paid an hourly wage and a commission
based on sales volume.
The company uses electronic cash registers to record each transaction. The
salesperson enters his or her employee number at the beginning of his/her shift. For
each sale, the salesperson rings up the order by scanning the item’s bar code, which
then displays the item’s description, unit price, and quantity (each item must be
scanned). The cash register automatically assigns a consecutive number to each
transaction. The cash register prints a sales receipt that shows the total, any
discounts, the sales tax, and the grand total.
The salesperson collects payment from the customer, gives the receipt to the
customer, and either directs the customer to the warehouse to obtain the items
purchased or makes arrangements with the shipping department for delivery. The
salesperson is responsible for using the system to determine whether credit card sales
are approved and for approving both credit sales and sales paid by check. Sales
returns are handled in exactly the reverse manner, with the salesperson issuing a
return slip when necessary.
At the end of each day, the cash registers print a sequentially ordered list of sales
receipts and provide totals for cash, credit card, and check sales, as well as cash and
credit card returns. The assistant manager reconciles these totals to the cash register
tapes, cash in the cash register, the total of the consecutively numbered sales invoices,
and the return slips. The assistant manager prepares a daily reconciled report for the
store manager’s review.
Cash sales, check sales, and credit card sales are reviewed by the manager, who
prepares the daily bank deposit. The manager physically makes the deposit at the
bank and files the validated deposit slip. At the end of the month, the manager
performs the bank reconciliation. The cash register tapes, sales invoices, return slips,
and reconciled report are mailed daily to corporate headquarters to be processed with
files from all the other stores. Corporate headquarters returns a weekly Sales and
Commission Activity Report to each store manager for review.
Please respond to the following questions about Spring Water Spa Company’s
operations: (CMA exam adapted)
a. The fourth component of the COSO ERM framework is risk assessment. What
risk(s) does Spring Water face?
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a. Control strengths in Spring
Water’s sales/cash receipts
b. Type of
control
activity
c. Problems avoided/Risks mitigated by the
controls
1. All 15 stores use the same
electronic, barcode-based
system for recording and
controlling sales transactions.
Proper
authorization of
transactions and
activities.
-Difficulty in managing and auditing all stores and
in making system changes.
-Barcodes automatically identify item description,
unit price, and quantity.
- Ensures mechanical accuracy of all transactions
and recording processes.
-Automatic receipt generation helps ensure all
transactions are entered into system.
2. Transactions are sequentially
numbered by the cash register.
Design and use
of documents
and records.
-Minimizes employee error and theft.
-Minimizes undetected or lost invoices.
-Provides an audit trail for invoices.
3. The cash receipts, checks,
credit cards, sales returns, and
cash register tapes are
reconciled.
Independent
check.
-Reduces the risk of theft or fraud and employee
error.
4. The bank deposit is prepared
and deposited by the manager.
Segregation of
duties.
-Reduces the risk of theft or fraud and employee
error.
5. Segregating the sale of goods
from the delivery of goods.
Segregation of
duties.
-Customers not having access to goods reduces
shoplifting, customer/clerk collusion, and other
theft.
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e. How might Spring Water improve its system of controls?
• The bank reconciliation should be performed by someone other than the manager
who makes the deposits.
• Sales people should never be allowed to authorize credit sales. At Spring Water,
the sales person authorizes credit purchases and approves payments made by check.
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7.12 PriceRight Electronics (PEI) is a small wholesale discount supplier of electronic
instruments and parts. PEI’s competitive advantage is its deep-discount, three-day
delivery guarantee, which allows retailers to order materials often to minimize in-
store inventories. PEI processes its records with stand-alone, incompatible computer
systems except for integrated enterprise resource planning (ERP) inventory and
accounts receivable modules. PEI decided to finish integrating its operations with
more ERP modules, but because of cash flow considerations, this needs to be
accomplished on a step-by-step basis.
It was decided that the next function to be integrated should be sales order
processing to enhance quick response to customer needs. PEI implemented and
modified a commercially available software package to meet PEI’s operations. In an
effort to reduce the number of slow-paying or delinquent customers, PEI installed
Web-based software that links to the Web site of a commercial credit rating agency
to check customer credit at the time of purchase. The following are the new sales
order processing system modules:
• Sales. Sales orders are received by telephone, fax, e-mail, Web site entry, or
standard mail. They are entered into the sales order system by the Sales
department. If the order does not cause a customer to exceed his credit limit, the
system generates multiple copies of the sales order.
• Credit. When orders are received from new customers, the system automatically
accesses the credit rating Web site and suggests an initial credit limit. On a daily
basis, the credit manager reviews new customer applications for creditworthiness,
reviews the suggested credit limits, and accepts or changes the credit limits in the
customer database. On a monthly basis, the credit manager reviews the accounts
receivable aging report to identify slow-paying or delinquent accounts for potential
revisions to or discontinuance of credit. As needed, the credit manager issues credit
memos for merchandise returns based on requests from customers and forwards
copies of the credit memos to Accounting for appropriate account receivable
handling.
• Warehousing. Warehouse personnel update the inventory master file for inventory
purchases and sales, confirm availability of materials to fill sales orders, and
establish back orders for sales orders that cannot be completed from stock on hand.
Warehouse personnel gather and forward inventory to Shipping and Receiving
along with the corresponding sales orders. They also update the inventory master
file for merchandise returned to Receiving.
• Shipping and receiving. Shipping and Receiving accepts inventory and sales orders
from Warehousing, packs and ships the orders with a copy of the sales order as a
packing slip, and forwards a copy of the sales order to Billing. Customer inventory
returns are unpacked, sorted, inspected, and sent to Warehousing.
• Accounting. Billing prices all sales orders received, which is done approximately 5
days after the order ships. To spread the work effort throughout the month,
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customers are placed in one of six 30-day billing cycles. Monthly statements,
prepared by Billing, are sent to customers during the cycle billing period.
Outstanding carry forward balances reported by Accounts Receivable and credit
memos prepared by the credit manager are included on the monthly statement.
Billing also prepares electronic sales and credit memos for each cycle. Electronic
copies of invoices and credit memos are forwarded to Accounts Receivable for entry
into the accounts receivable master file by customer account. An aging report is
prepared at the end of each month and forwarded to the credit manager. The
general accounting office staff access the accounts receivable master file that reflects
total charges and credits processed through the accounts receivable system for each
cycle. General accounting runs a query to compare this information to the electronic
sales and credit memo and posts the changes to the general ledger master file.
(CMA exam adapted)
a. Identify the internal control strengths in PEI’s system
b Identify the internal control weaknesses in PEI’s system, and suggest ways to correct
them.
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Weakness 1: The Credit Department only checks the accounts receivable aging report at
month-end, which delays the identification of slow or non-paying customers for potential
credit status changes.
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SUGGESTED SOLUTIONS TO THE CASE
7.1 Nino Moscardi, president of Greater Providence Deposit & Trust (GPD&T), received
an anonymous note in his mail stating that a bank employee was making bogus loans.
Moscardi asked the bank’s internal auditors to investigate the transactions detailed in
the note. The investigation led to James Guisti, manager of a North Providence
branch office and a trusted 14-year employee who had once worked as one of the
bank’s internal auditors. Guisti was charged with embezzling $1.83 million from the
bank using 67 phony loans taken out over a three-year period.
Court documents revealed that the bogus loans were 90-day notes requiring no
collateral and ranging in amount from $10,000 to $63,500. Guisti originated the loans;
when each one matured, he would take out a new loan, or rewrite the old one, to pay
the principal and interest due. Some loans had been rewritten five or six times.
The 67 loans were taken out by Guisti in five names, including his wife’s maiden
name, his father’s name, and the names of two friends. These people denied receiving
stolen funds or knowing anything about the embezzlement. The fifth name was James
Vanesse, who police said did not exist. The Social Security number on Vanesse’s loan
application was issued to a female, and the phone number belonged to a North
Providence auto dealer.
Lucy Fraioli, a customer service representative who cosigned the checks, said Guisti
was her supervisor and she thought nothing was wrong with the checks, though she
did not know any of the people. Marcia Perfetto, head teller, told police she cashed
checks for Guisti made out to four of the five persons. Asked whether she gave the
money to Guisti when he gave her checks to cash, she answered, “Not all of the time,”
though she could not recall ever having given the money directly to any of the four,
whom she did not know.
Guisti was authorized to make consumer loans up to a certain dollar limit without
loan committee approvals, which is a standard industry practice. Guisti’s original
lending limit was $10,000, the amount of his first fraudulent loan. The dollar limit was
later increased to $15,000 and then increased again to $25,000. Some of the loans,
including the one for $63,500, far exceeded his lending limit. In addition, all loan
applications should have been accompanied by the applicant’s credit history report,
purchased from an independent credit rating firm. The loan taken out in the fictitious
name would not have had a credit report and should have been flagged by a loan
review clerk at the bank’s headquarters.
News reports raised questions about why the fraud was not detected earlier. State
regulators and the bank’s internal auditors failed to detect the fraud. Several reasons
were given for the failure to find the fraud earlier. First, in checking for bad loans,
bank auditors do not examine all loans and generally focus on loans much larger than
the ones in question. Second, Greater Providence had recently dropped its computer
services arrangement with a local bank in favor of an out-of-state bank. This
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changeover may have reduced the effectiveness of the bank’s control procedures.
Third, the bank’s loan review clerks were rotated frequently, making follow-up on
questionable loans more difficult.
Guisti was a frequent gambler and used the embezzled money to pay gambling debts.
The bank’s losses totaled $624,000, which was less than the $1.83 million in bogus
loans, because Guisti used a portion of the borrowed money to repay loans as they
came due. The bank’s bonding company covered the loss.
The bank experienced other adverse publicity prior to the fraud’s discovery. First, the
bank was fined $50,000 after pleading guilty to failure to report cash transactions
exceeding $10,000, which is a felony. Second, bank owners took the bank private after
a lengthy public battle with the State Attorney General, who alleged that the bank
inflated its assets and overestimated its capital surplus to make its balance sheet look
stronger. The bank denied this charge.
1. How did Guisti commit the fraud, conceal it, and convert the fraudulent actions
to personal gain?
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2. Good internal controls require that the custody, recording, and authorization
functions be separated. Explain which of those functions Guisti had and how the
failure to segregate them facilitated the fraud.
Authorization: Guisti was authorized to make consumer loans up to $10,000 (later
3. Identify the preventive, detective, and corrective controls at GPD&T and discuss
whether they were effective.
8. Are there any indications that the internal environment at Greater Providence
may have been deficient? If so, how could it have contributed to this
embezzlement?
