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d. An employee of the finishing department walked off with several parts from the
storeroom and recorded the items in the inventory ledger as having been issued
to the assembly department.
PROBLEM: Employees can commit and conceal fraud when they have access to
e. A cashier cashed a check from a customer in payment of an account receivable,
pocketed the cash, and concealed the theft by properly posting the receipt to the
customer’s account in the accounts receivable ledger.
PROBLEM: The cashier had custody of the checks and was responsible for posting
f. Several customers returned clothing purchases. Instead of putting the clothes
into a return bin to be put back on the rack, a clerk put the clothing in a
separate bin under some cleaning rags. After her shift, she transferred the
clothes to a gym bag and took them home.
PROBLEM: The clerk was authorized to accept the return, grant credit, and had
custody of the inventory. It is also possible that the clerk may have had responsibility
Ch. 7: Control and Accounting Information Systems
g. A receiving clerk noticed that four cases of MP3 players were included in a
shipment when only three were ordered. The clerk put the extra case aside and
took it home after his shift ended.
PROBLEM: The receiving clerk had custody of arriving goods, counted the goods,
and compared the count to a purchase order. The problem is that, while the receiving
h. An insurance claims adjuster had check signing authority of up to $6,000. The
adjuster created three businesses that billed the insurance company for work not
performed on valid claims. The adjuster wrote and signed checks to pay for the
invoices, none of which exceeded $6,000.
PROBLEM: The adjuster had authorization to add vendors to vendor master file,
authorization to write checks up to $6,000, and had custody of the signed the checks.
i. An accounts payable clerk recorded invoices received from a company that he
and his wife owned and authorized their payment.
PROBLEM: The accounts payable clerk had recording duties and he authorized
payments.
Accounting Information
Systems
j. A cashier created false purchase return vouchers to hide his theft of several
thousand dollars from his cash register.
PROBLEM: The cashier had recording (creating return vouchers), custody (cash in
the cash register), and authorization (authorize the return of goods) duties.
k. A purchasing agent received a 10% kickback of the invoice amount for all
purchases made from a specific vendor.
PROBLEM: The purchasing agent has both recording (prepare the purchase order)
and authorization (select a vendor from a list of authorized vendors) duties. The
purchasing agent gets custody to cash when the vendor gives her the kickback.
Ch. 7: Control and Accounting Information Systems
7.3 The following description represents the policies and procedures for agent expense
reimbursements at Excel Insurance Company.
After the expenses are approved, the branch manager sends the expense report to the
home office. There, accounting records the transaction, and cash disbursements
prepares the expense reimbursement check. Cash disbursements sends the expense
reimbursement checks to the branch manager, who distributes them to the agents.
At the end of each month, internal audit at the home office reconciles the expense
reimbursements. It adds the total dollar amounts on the expense reports from each
branch, subtracts the sum of the dollar totals on each branch’s Cash Advance
Approval form, and compares the net amount to the sum of the expense
reimbursement checks issued to agents. Internal audit investigates any differences.
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Strengths
Weaknesses
Authorization
Excel has a formal statement of policies
and procedures for agent reimbursements.
There is no limit on the agent’s total weekly
expenditures or cash advances.
Recording
Accounting receives approved expense
reports and cash advance forms. This
facilitates the correct recording of all
authorized transactions.
The Branch Manager does not retain a copy of
expense reports or cash advances for audit
purposes.
The expense report is not checked for mathematical
Safeguarding
Expense reimbursement checks are issued
by the cash disbursements department.
Cash disbursements are made only after
receipt of an approved expense report or
Cash Advance Approval form.
Supporting documentation is not required for all
expenditures.
A copy of the Cash Advance Approval form should
be sent to the Branch Office Cashier so it can
compare it with the one submitted by the agent.
Reconciliation
There is no reconciliation of Branch Office
Cashier disbursements with Cash Advance
Approval forms.
Expense reports must be approved by the
Branch Manager prior to payment.
Expense reimbursement checks are sent to the
Branch Manager for distribution rather than to the
agent. This allows the Branch Manager to submit a
Ch. 7: Control and Accounting Information Systems
7.4 The Gardner Company, a client of your firm, has come to you with the following
problem. It has three clerical employees who must perform the following functions:
a. Maintain the general ledger
b. Maintain the accounts payable ledger
c. Maintain the accounts receivable ledger
Assuming equal abilities among the three employees, the company asks you to assign
the eight functions to them to maximize internal control. Assume that these employees
will perform no accounting functions other than the ones listed.
a. List four possible unsatisfactory pairings of the functions
All five of the unsatisfactory pairings below involve custody of cash and a recording
function that would allow a fraud perpetrator to conceal a theft.
1. General ledger – cash receipts. With custody to cash, this person could steal
2. Accounts receivable ledger – cash receipts. With custody to cash, this person
3. Bank reconciliation – cash receipts. With custody to cash, this person could
steal cash receipts and conceal the theft by falsifying (recording) the bank
reconciliation.
4. Credits on returns and allowances – cash receipts. This person could
5. Accounts payable ledger – prepare checks for signature. A person with both
6. Maintain accounts receivable – issue credit memos – this combines
authorization and recording. A person with both of these responsibilities could
write off accounts for friends.
b. State how you would distribute the functions among the three employees.
Assume that with the exception of the nominal jobs of the bank reconciliation
Accounting Information
Systems
and the issuance of credits on returns and allowances, all functions require an
equal amount of time.
Any distribution that avoids all of the above unsatisfactory combinations and spreads
the workload evenly is acceptable. The key is not to have anyone with both custody
Ch. 7: Control and Accounting Information Systems
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?
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
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?
Considering only the estimated costs and benefits, procedure B 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.
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(as a form of insurance premium) to reduce the risk of loss to the smallest
possible level.
e. Use the Goal Seek function in Microsoft Excel to determine the likelihood of
occurrence without the control and the reduction in expected loss if the net
benefit/cost is 0. Do this for procedure A, procedure B, and both procedures together
Control Procedure A – Goal Seek-setup.
Control Procedure A – Goal Seek – solved.
Ch. 7: Control and Accounting Information Systems
Control Procedure B – Goal Seek-setup.
Control Procedure B – Goal Seek – solved.
Control Procedure Both – Goal Seek-setup.
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Control Procedure Both – Goal Seek – solved.
Ch. 7: Control and Accounting Information Systems
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.
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.
For each of the eight conditions detected by the Covington internal audit staff:
a. Describe a possible cause of the condition.
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#
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.
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
2
Bad debt write-offs are prepared and
approved by the same employee.
Collusion between customers and the
Require all bad debt write-offs to be approved
3
Occasional discrepancies between
physical inventory counts and
perpetual inventory records.
Unauthorized access to physical
inventory and/or inventory records.
Limit physical and logical access to the
inventory records to authorized employees.
Ch. 7: Control and Accounting Information Systems
4
Alterations to physical inventory
counts and perpetual inventory
records
Unauthorized access to inventory
records.
Limit physical and logical access to the
inventory records to authorized employees.
5
Many customer refunds and credits.
Collusion among customers,
Segregate duties so refunds and credits are
6
Many original documents are missing
or lost. However, there are substitute
copies of all missing originals.
Failure to use pre-numbered documents.
Use pre-numbered documents to facilitate the
control and identification of documents.
Count inventory to be shipped before it is
removed from the storeroom, when received by
shipping, and when shipped; reconcile counts.
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7
An unexplained decrease in the gross
profit percentage has occurred.
Granting unauthorized discounts or
credits to customers.
Customers given lower, preferential sales
prices
Require the approval of a responsible party
before granting customer discounts or credits.
Require the approval of a responsible party
before granting preferential sales prices
8
Many documents are not approved.
Lack of, misunderstanding of, or failure
to comply with written procedures.
Prepare or update written procedures and train
employees using the procedures
Ch. 7: Control and Accounting Information Systems
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.
• Implement and communicate through proper training a policy regarding the theft of
company goods and services and the repercussions associated with 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
• Implement a better segregation of duties. The company controller should not be able to
order goods, specify shipment locations, and authorize payment for inventory.
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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
2. For efficiency and effectiveness, purchases of specialized goods and services are
3. Accounts payable maintains a list of employees who have purchase order approval
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
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
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.
Ch. 7: Control and Accounting Information Systems
a. For each internal control strength you identified, explain how the procedure
helps achieve good authorization, accounting, or asset protection control.
#
a. Why it is a strength
b. Why it is a weakness
b. Recommendation to
correct weakness
1
The use of pre-numbered
purchase orders allows all
POs to be accounted for.
identification.
User authorization means
the right materials and
quantities will be ordered.
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
2
It increases the potential for collusive
agreements.
The purchasing department
should approve orders before
the purchase, not before
payment is made.
Accounting Information
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6
Taking unearned cash discounts
causes additional paperwork when
disputed by suppliers and creates
animosity. This policy may lead to
fewer discounts being offered.
them after payment reduces
duplicate payments.
Pay suppliers on or before
the discount date.
Lost discounts should be
analyzed for cause and future
avoidance.
8
Proper protection of blank
checks (locked safe only
accessible to cash
disbursements department
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.
established and monitored.
Unlimited access to cash disbursement
documents (other than blank checks)
permits unauthorized alteration of
payables documents. This could result
A policy limiting access to
and physical protection of
accounts payable documents
and records should be
minimize errors and helps
Approved, unpaid invoices