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Ch. 7: Control and Accounting Information Systems
7.8 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
2. When the purchasing department receives either an inventory or an equipment
3. When equipment arrives, the user department installs it. The property, plant, and
equipment control accounts are supported by schedules organized by year of
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.
Weakness
Recommendation
1. No authorization form describing
2. Equipment purchases over a certain
The purchase requisition should include an item
Large sums of money can be spent on equipment.
3. Purchase requisitions for fixed
Authorized equipment acquisitions should be
Accounting Information
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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
6. Equipment is not tagged and
controlled to prevent theft.
7. Plant engineering is not helping
8. Machinery and equipment
accounting policies, including
Machinery and equipment should be subject to normal
receiving routines. In addition, plant engineering
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
Machinery and equipment accounting procedures,
including depreciation, must be updated periodically
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.
Ch. 7: Control and Accounting Information Systems
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.
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
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b. Based on your analysis, make a recommendation to management regarding the
control procedure.
Since the process yields an estimated net weekly benefit of $725, LRC should
c. 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
Solution: 6%
Ch. 7: Control and Accounting Information Systems
Without
Control
Process
With
Control
Process
Net
Difference
Expected
Cost of Production Data Reprocessing
$34,500
$34,500
Risk of Data Errors
6%
3%
Goal Seek Setup:
Accounting Information
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7-45
Goal Seek Solved:
Ch. 7: Control and Accounting Information Systems
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 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.
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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Spring Water’s sales/cash
receipts
control
activity
the controls
1. All 15 stores use the same
electronic, bar-code 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 identifies item
description, unit price, quantity.
- Ensures mechanical accuracy of all
transactions and recording processes.
-Automatic receipt generation helps ensure all
transactions are entered into system.
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.
Ch. 7: Control and Accounting Information Systems
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.
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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.
• 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.
• 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.
Ch. 7: Control and Accounting Information Systems
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
a. Identify the internal control strengths in PEI’s system
• The automated customer credit limit system suggests a new customer's credit limit on
a real-time basis. The Credit Manager establishes credit limits for new customers on
a daily basis so that new credit-worthy customers can have their orders filled in a
timely manner.
• Shipping and Receiving accept and inspect returned materials to assure the receipt
and identification of damaged materials and to limit credit returns.
• Warehouse personnel confirm the availability of materials to fill orders and prepare
back-orders for sales orders that cannot be filled with current stock.
b Identify the internal control weaknesses in PEI’s system, and suggest ways to correct
them.
Weakness 1: The Credit Department only checks the accounts receivable aging report at
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Correction: Require the credit manager to receive an acknowledgement from Shipping
and Receiving that the goods were returned in good condition before issuing a credit
memo. In addition, Accounting should not process any credit memos without receiving a
report of goods received from Shipping and Receiving.
Weakness 3: Warehouse personnel have responsibility for updating inventory records for
purchases and sales that can lead to inventory shrinkage.
purchase returns, which can lead to inventory shrinkage.
Correction: Have the warehouse create a daily purchases returned report for all returned
goods they receive from Receiving. This report should be sent to General Accounting for
comparison with a purchase return report prepared by Receiving.
Weakness 6: Inventory is not counted when received and then counted again when
received by the warehouse to prevent theft after items are received. In similar fashion,
Ch. 7: Control and Accounting Information Systems
Correction: Count and compare inventory counts as inventory enters the company and as
it arrives in warehousing; likewise count and compare inventory counts as it leaves
warehousing and arrives at shipping.
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SUGGESTED SOLUTIONS TO THE CASES
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.
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.
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,
Ch. 7: Control and Accounting Information Systems
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.
1. How did Guisti commit the fraud, conceal it, and convert the fraudulent actions
to personal gain?
Commit: James Guisti, a trusted 14-year employee and manager of a Greater
Providence Deposit & Trust’ branch office, was authorized to make consumer loans
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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
$15,000 and then $25,000) without loan committee approval. This authorization is
standard industry practice. He used this authority to create fraudulent loans.
3. Identify the preventive, detective, and corrective controls at GPD&T and discuss
whether they were effective.
Preventive: All bank loans exceeding Guist’s limit ($10,000, then $15,000 and then
$25,000) were supposed to be approved by a loan committee. This control was not
enforced or was not effective as Guisti was able to bypass it.
Ch. 7: Control and Accounting Information Systems
4. Explain the pressures, opportunities, and rationalizations that were present in
the Guisti fraud.
Pressures: Guisti was a frequent gambler and needed the money to pay gambling
debts.
5. Discuss how Greater Providence Deposit & Trust might improve its control
procedures over the disbursement of loan funds to minimize the risk of this type
of fraud. In what way does this case indicate a lack of proper segregation of
duties?
Loan funds should generally not be disbursed in cash. Better control would be
established by depositing the funds in a checking account in the borrower's name or
by issuing a bank check to the borrower.
6. Discuss how Greater Providence might improve its loan review procedures at
bank headquarters to minimize its fraud risk. Was it a good idea to rotate the
assignments of loan review clerks? Why or why not?
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A system should be in place at the bank's headquarters to maintain data on all
outstanding bank loans. This system should flag all loans that have been made in
excess of the loan officer's lending limit. The authenticity of these loans should be
scrutinized by internal auditors or other bank officials independent of the loan officer.
Disciplinary action should be taken when a loan officer extends a loan that is greater
than his loan limit.
7. Discuss whether Greater Providence’s auditors should have been able to detect
this fraud.
Audits are not guaranteed to detect fraud. It is too costly for auditors to examine
every loan, so they generally examine a systematically selected sample. It makes
sense for auditors to focus on larger loans, since that is where the greatest exposure is.
Ch. 7: Control and Accounting Information Systems
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?
There are three indications of potential deficiencies in the bank's control environment.
