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Case study: Internal control

Equestrian Co manufactures smartphones and tablets. Its main customers are retailers who then sell to the general public. The company’s manufacturing is spread across five sites and goods are stored in its nine warehouses located across the country. You are an audit supervisor of Baseball & Co and in preparation for the forthcoming audit for the year ending 30 June 20X7, you are reviewing the following notes your audit manager has provided you with in relation to the company’s internal controls.

Equestrian Co has a small internal audit (IA) department. During the year, IA started a programme of physically verifying the company’s assets and comparing the results to the non-current assets register, as this type of reconciliation had not occurred for some time. To date only 15% of assets have had their existence confirmed as IA has experienced significant staff shortages and several members of the current IA team are new to Equestrian Co.

During the year, Equestrian Co conducted an extensive reorganization of its manufacturing process to improve efficiency. Due to the significant number of employee changes required, the human resources department (HR) has been very busy and to ease their workload during this period, the payroll department has assisted by setting up any new employees who have joined the company. In January 20X7, the wage rate paid to employees was increased by the HR director and he notified payroll by emailing the payroll supervisor

A new sales ledger system was introduced in May 20X6 and will continue to be run in parallel with the old system until IA has completed its checks between the two systems. New customers obtained by the sales team are required to undergo a full credit check; on the basis of this, a credit limit is proposed by sales staff and approved by the sales director and these credit limits remain static in the sales system.

Monthly perpetual inventory counts are undertaken at each of the nine warehouses, as a full year-end inventory count is too disruptive for the company. High value items are stored in a secure area in each warehouse. Access is via a four digit code, which for convenience is the same across all sites. Due to the company’s reorganization program, some of the monthly inventory counts were not performed.

Bank reconciliations are undertaken monthly by an accounts clerk and details of all reconciling items are included. Where the sum of the reconciling items is significant, the reconciliation is sent to the financial controller for review. In order to maximize cash balances, the finance director approves all purchase invoices for payment 75 days after receipt of the invoice.

Required: Identify and explain deficiencies in Equestrian Co’s internal controls and provide a recommendation to address each of these deficiencies.

Control deficiency

Control recommendation

§ Physical verification of assets within the non-current asset register has not been undertaken for some time. A current program has started but is only 15% complete, due to staff shortages.

If non-current assets are not physically verified on a regular basis, there is an increased risk of assets being misappropriated or misplaced as there is no check that the assets still exist in their correct location.

§ Equestrian Co has experienced significant staff shortages within their internal audit (IA) department. In addition, several members of the current IA team are new to the company.

Maintaining an IA department is an important control as it enables senior management to test whether controls are operating effectively within the company. If the team has staff shortages or lack of experience, this reduces the effectiveness of this monitoring control

§ During the year, the human resources (HR) department has been busy; therefore the payroll department has set up new joiners to the company.

This is a lack of segregation of duties, as employees are able to set up new joiners in the payroll system and process their pay, this leads to an increased risk of fictitious/duplicate employees being set up.

§ The wage rate has been increased by the HR director and notified to the payroll supervisor by email. As payroll can be a significant expense for a business, any decision to increase this should be made by the board as a whole and not just by the HR director.

In addition, the notification of the payroll increase was via email and the payroll supervisor was able to make changes to the payroll standing data without further authorization. This increases the risk of fraud or errors arising within payroll.

§ New customers undergo a credit check, after which a credit limit is proposed by the sales staff and approved by the sales director, these credit limits are not reviewed after this.

Over a period of time it may be that the customers’ credit limits have been set too high, leading to irrecoverable debts, or too low, leading to a loss of sales.

§ High value inventory is stored in a secure location across all nine warehouses and access is via a four digit code, which is common to all sites.

As the code is the same across all sites, this significantly increases the risk of fraud. A considerable number of people will be aware of the codes and could access inventory at any of the nine sites.

§ Monthly perpetual inventory counts are supposed to be undertaken at each of the nine warehouses, but some of these are outstanding.

§ In order to rely on inventory records for decision making and the year-end financial statements, all lines of inventory must be counted at least once a year, with high value or high turnover items counted more regularly. If the counts are outstanding, some goods may not be counted, and the inventory records may be incorrect.

§ The bank reconciliations are only reviewed by the financial controller if the sum of reconciling items is significant; therefore some reconciliations are not being reviewed. The financial controller relies solely on the accounts clerk’s notification that the bank reconciliations require review

The bank reconciliations could contain significant errors, but a low overall amount of reconciling items, as there could be compensating errors which cancel each other out.

Bank reconciliations are a key control which reduces the risk of fraud. If they are not reviewed, then this reduces its effectiveness and also results in a lack of assurance that bank reconciliations are being carried out at all or on a timely basis.

§ Invoices are authorized by the finance director, but payment is only made 75 days after receipt of the invoice. There is the risk that Equestrian Co is missing out on early settlement discounts.

Also, failing to pay in accordance with the supplier’s payment terms can lead to a loss of supplier goodwill as well as the risk that suppliers may refuse to supply goods to the company.

§ Additional resources should be devoted to completing the physical verification of all assets within the register. If any assets cannot be located, they should be written off. Following this full review, on a monthly basis a sample of assets at the sites should be agreed back to the register to confirm existence.

§ Senior management should consider recruiting additional employees to join the IA department.

In the interim, employees from other departments, such as finance, could be seconded to IA to assist them with the internal audits, provided these reviews do not cover controls operating in the department where the employees normally work.

§ The HR director should as a matter of urgency review the workloads of the department to assess whether other tasks can be reprioritized as payroll should cease to set up new joiners. This role must immediately revert back to HR to undertake. Additionally, a review should be undertaken of all new joiners set up by payroll with agreement to employee files to confirm that all new employees are bona fide.

§ All increases of pay should be proposed by the HR department and then formally agreed by the board of directors. Upon agreement of the pay rise, a written notification of the board decision should be sent to the payroll supervisor who enters the revised pay rate into the system. This change should trigger an exception report for the payroll director, and the new rate should not go live until the director has signed off the changes.

§ Credit limits should continue to be approved by the sales director; however, on a regular basis the sales director should review these limits based on order history and payment record§ The access codes for all of the sites should be changed. Each site should have a unique code, known to a small number of senior warehouse employees. These codes should be changed on a regular basis.

§ The program of perpetual inventory counts should be reviewed for omissions. Any lines which have been missed out should be included in the remaining count§

At the year end, if any lines are identified as having not been counted, the company should organize an additional count to ensure that all items are confirmed to inventory records.

§ The bank reconciliations should be reviewed by the financial controller on a monthly basis, even if the reconciling items are not significant, and he should evidence his review by way of signature on the bank reconciliation.

§ The policy of making payment after 75 days should be reviewed. Consideration should be given to earlier payment if the settlement discounts are sufficient. If not, invoices should be paid in accordance with the supplier’s payment terms.