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Answer Ch 07

By Grace Ruiz,2014-09-20 11:54
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Answer Ch 07

     Accounting Information Systems

    Chapter 7 Solutions

    Q7.1 Answer the following questions about the audit of Springer’s Lumber & Supply

     a. What deficiencies existed in the internal environment at Springers?

     The "internal environment" refers to the tone or culture of a company and helps determine how risk consciousness employees are. It is the foundation for all other ERM components, providing discipline and structure. It is essentially the same thing as the control environment in the internal control framework.

    The internal environment also refers to management's attitude toward internal control, and to how that attitude is reflected in the organization's control policies and procedures. At Springer's, several deficiencies in the control environment are apparent:

    1. Management authority is concentrated in three family members, so there are few, if any,

    checks and balances on their behavior. In addition, several other relatives and friends of the

    family are on the payroll.

    2. Since the company has a "near monopoly" on the business in the Bozeman area, few

    competitive constraints restrain prices, wages, and other business practices. 3. Lines of authority and responsibility are loosely defined, which make it difficult to identify

    who is responsible for problems or decisions.

    4. Management may have engaged in "creative accounting" to make its financial performance

    look better, which suggests a management philosophy that could encourage unethical behavior

    among employees.

    b. Do you agree with the decision to settle with the Springers rather than to prosecute them for fraud and embezzlement? Why or why not?

    Whether or not to settle with the Springers is a matter of opinion, with reasonable arguments on both sides of the issue.

     The reasons for reaching a settlement are clearly stated: the difficulty of obtaining convictions

    in court, and the possible adverse effects on the company's market position. On the other hand, the evidence of fraud here seems strong. If this kind of behavior is not

    penalized, then the perpetrators may be encouraged to do it again, with future adverse

    consequences to society.

    c. Should the company have told Jason and Maria the results of the high-level audit? Why or why not?

    Whether or not Jason and Maria should have been told the results of the high-level audit is also a matter of opinion. The investigative team is apparently trying to keep its agreement to maintain silence by telling as few people as possible what really happened. On the other hand, Jason and Maria were the ones who first recognized the problems; it seems only right that they be told about the outcome.

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    Many lessons may be drawn from this story.

    1. Auditors should view the condition of an organization's control environment as an important

    indicator of potential internal control problems.

    2. Fraud is more easily perpetrated and concealed when many perpetrators are involved, and

    especially when management is involved.

    3. Purchasing and payroll are two areas that are particularly vulnerable to fraud.

    4. Determining whether fraud has actually occurred is sometimes quite difficult, and proving that

    it has occurred is even more difficult.

    5. Frauds do occur, so auditors must always be alert to the possibility of fraud.

    6. Auditors should not accept management's explanations for questionable transactions at face

    value, but should do additional investigative work to corroborate such explanations.

    Q7.2 Effective segregation of duties is sometimes not economically feasible in a small business. What internal control elements do you think can help compensate for this threat?

     Small companies can do the following things to compensate for their inability to implement an adequate segregation of duties:

     Effective supervision and independent checks performed by the owner/manager may be the most

    important element of control in situations where separation of functions cannot be fully achieved. In

    very small businesses, the owner-manager may find it necessary to supervise quite extensively. For

    example, the manager could reconcile the bank account, examine invoices, etc. Fidelity bonding is a second form of internal control that is critical for persons holding positions of

    trust that are not entirely controlled by separation of functions.

     Document design and related procedures are also important to internal control in this situation.

    Documents should be required with customer returns to encourage customer audit. Document design should include sequential prenumbering to facilitate subsequent review.

     Where appropriate, employees should be required to sign documents to acknowledge responsibility

    for transactions or inventories.

     In small organizations, management can use computers to perform some of the control functions that

    humans perform in manual systems. For example, the computer can:

    ; Check all customer numbers to make sure they are valid

    ; Automatically generate purchase orders and have a member of management or a designated

    buyer authorize them.

    Q7.3 One function of the AIS is to provide adequate controls to ensure the safety of organizational

    assets, including data. However, many people view control procedures as “red tape.” They also believe

    that, instead of producing tangible benefits, business controls create resentment and loss of company

    morale. Discuss this position.

    Well-designed controls should not be viewed as “red tape” because they can actually improve both efficiency and effectiveness. The benefits of business controls are evident if one considers the losses that frequently occur due to the absence of controls.

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    Consider a control procedure mandating weekly backup of critical files. Regular performance of this control prevents the need to spend a huge amount of time and money recreating files that are lost when the system crashes, if it is even possible to recreate the files at all. Similarly, control procedures that require workers to design structured spreadsheets can help ensure that the spreadsheet decision aids are auditable and that they are documented well enough so that other workers can use them.

    It is probably impossible to eliminate resentment or loss of morale among all employees, but these factors may be minimized if controls are administered fairly and courteously.

    Of course, there is a cost-benefit tradeoff in implementing internal controls. If an organization has too many controls, this may justifiably generate resentment and loss of morale among employees. Controls having only marginal economic benefit may be rejected for this reason.

    Another factor is the obtrusiveness of the controls. When the user sees no clear need or purpose to a control it can appear to be there only to control them and little more than that. When the user does not understand their purpose, controls can often provoke resentment.

    Q7.4 In recent years, Supersmurf’s external auditors have given clean opinions on its financial statements

    and favorable evaluations of its internal control systems. Discuss whether it is necessary for this corporation to take any further action to comply with the SarbanesOxley Act.

    The Sarbanes-Oxley Act of 2002 (SOX) applies to publicly held companies and their auditors and was intended to prevent financial statement fraud, make financial reports more transparent, provide protection to investors, strengthen the internal controls at public companies, and punish executives who perpetrate fraud.

    SOX has had a material impact on the way boards of directors, management, and accountants of publicly held companies operate. It has also had a dramatic impact on CPAs of publicly held companies and the audits of those companies.

    As a result of SOX, Supersmurf’s management and their audit committee must take a more active role in the financial disclosure process. Some of the more prominent roles include:

     Audit Committee

     Audit committee members must be on the company’s board of directors and be independent of the

    company. One member of the audit committee must be a financial expert.

     Audit committees hire, compensate, and oversee any registered public accounting firm that is

    employed

     Auditors report to the audit committee and not management

     Audit committees must pre-approve all audit and non-audit services provided by its auditor

     Management

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     The CEO and CFO at companies with more than $1.2 billion in revenue must prepare a statement

    certifying that their quarterly and annual financial statements and disclosures are fairly presented,

    were reviewed by management, and are not misleading.

     Management must prepare an annual internal control report that states

    o Management is responsible for establishing and maintaining an adequate internal control

    structure

    o Management assessed the company’s internal controls and attests to their accuracy, including

    notations of significant defects or material noncompliance found during their internal control

    tests.

    o Auditors were told about all material internal control weaknesses and fraud

    o Significant changes to controls after management’s evaluation were disclosed and corrected

     Management must base its evaluation on a recognized control framework, developed using a due-

    process procedure that allows for public comment. The report must contain a statement identifying

    the framework used by management to evaluate internal control effectiveness. The most likely

    framework is one of those formulated by COSO and discussed in the chapter.

     SOX also specifies that a company’s auditor must attest to as well as report on management’s

    internal control assessment.

    Q7.5 When you go to a movie theater, you buy a prenumbered ticket from the cashier. This ticket is

    handed to another person at the entrance to the movie. What kinds of irregularities is the theater trying

    to prevent? What controls is it using to prevent these irregularities? What remaining risks or exposures

    can you identify?

    There are two reasons for using tickets.

    1. The theater is trying to prevent cashiers from stealing cash by providing greater control over cash

    receipts. You cannot get into the theater without a ticket so you never give cash to a cashier without

    insisting on a ticket. That makes it much harder for a cashier to pocket cash.

    2. Prenumbered tickets are also used so cashiers cannot give tickets to their friends. The number of

    tickets sold at the cashier counter can be reconciled with the number of tickets taken by the usher

    letting patrons into the theater.

    Reconciling the cash in the register to the tickets sold and then reconciling the number of tickets sold to the number collected by the ticket-taker helps prevent the theft of cash and giving tickets away to friends. Despite these controls, the following risks still exist:

     The ticket-taker can let friends into the theater without tickets.

     The ticket-taker may take money from theater patrons, pocketing the cash and letting them enter

    without a ticket.

     The cashier and the ticket-taker may collude in selling admittances without issuing tickets and then

    split the proceeds.

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    Q7.6 Some restaurants use customer checks with prenumbered sequence codes. Each food server uses these checks to write up customer orders. Food servers are told not to destroy any customer checks; if a mistake is made, they are to void that check and write a new one. All voided checks are to be turned in to the manager daily. How does this policy help the restaurant control cash receipts?

    The fact that all documents are prenumbered provides a means for accounting for their use and for detecting unrecorded transactions. Thus, a missing check indicates a meal for which a customer did not pay. Since each server has his or her own set of checks, it is easy to identify which server was responsible for that customer.

    This policy may help to deter theft (e.g., serving friends and not requiring them to pay for the meal, or pocketing the customer’s payment and destroying the check) because a reconciliation of all checks will reveal that one or more are missing.

    P7.1 The information you have obtained suggests potential problems relating to Go-Go’s internal

    environment. Identify the problems, and explain them in relation to the internal environment concepts discussed in this chapter

     The underlined items correspond to one of the 7 elements of the internal environment covered in the text.

a. You met with Go-Go’s audit committee, which consists of the corporate controller, treasurer,

    financial vice president, and budget director.

    PROBLEM: Section 301 of the Sarbanes-Oxley Act of 2002 (SOX) applies to publicly held

    companies and their auditors. It requires audit committee members to be on the company’s board

    of directors and to be independent of the company. That is not the case at Go-Go Corporation.

    SOLUTION: All members of the audit committee should be members of the Board of Directors.

    They must also be independent of the company meaning none of the audit committee can be

    employees. The audit committee is responsible for overseeing the corporation’s internal control

    structure, its financial reporting process, and its compliance with related laws, regulations, and

    standards. The committee works closely with the corporation’s external and internal auditors. SOX

    requires audit committees to be responsible for hiring, compensating, and overseeing the auditors

    and for auditors to report all critical accounting policies and practices to the audit committee.

    b. You recognized the treasurer as a former aide to Ernie Eggers, who was convicted of fraud

    several years ago.

    PROBLEM: Because the position of corporate treasurer involves managing cash and other financial

    assets, it is critical that the position be filled with someone of unquestioned commitment to integrity

    and ethical values. This question presents somewhat of a dilemma. Here are the two sides of that

    dilemma.

    On the one hand, just because the treasurer worked for someone that turned out to be dishonest does

    NOT mean the treasurer is dishonest as well. Everyone should be judged on his or her own merits,

    not those of someone else. Therefore, you need to be careful not to assume automatically that the

    treasurer is dishonest.

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    On the other hand, the fact that the treasurer has been an aide to someone convicted of fraud should

    raise questions in your mind. You should approach all audits with the requisite skeptical attitude.

    That skeptical attitude should be heightened due to his past associations.

    SOLUTION: Though you may not have specific information linking the corporate treasurer to the

    prior fraud, this information should indicate a need to examine carefully the corporation's human

    resource standards and personnel policies and practices with respect to hiring.

    c. Management explained its plans to change accounting methods for depreciation from the

    accelerated to the straight-line method. Management implied that if your firm does not concur

    with this change, Go-Go will employ other auditors.

    PROBLEM: Why would a company want to move from an accelerated depreciation method to one

    with a lower depreciation write-off? One reason is that it reduces depreciation expense, thereby

    increasing net income and, potentially, the company’s stock price. Alternatively, they may be

    looking for a way to mask, or hide, other company problems that will affect net income.

    SOLUTION: The company should have a logical and defensible reason for changing accounting

    methods, other than just to increase net income and the stock price. The company may be willing to

    go to great lengths to "get their own way" with respect to an important financial reporting matter.

    The commitment to ethics issue involves questionable practices, desire to make the numbers, etc. If

    management does not have a good reason for the desired change, company management’s

    commitment to integrity and ethical values should be carefully evaluated.

     It is also possible that there is a problem with management's philosophy and operating style.

    Management’s philosophy and operating style relates to risk-taking propensity and problems with

    philosophy and operating style are similar to carelessnessn or recklessness.

     It is important to note that management can be careless, yet ethical; they can also be careful, yet

    unethical.

d. You learned that the financial vice president manages a staff of five internal auditors.

     PROBLEM: The internal audit function is not organizationally independent of the accounting and

    finance functions.

     SOLUTION: Organization structure and board of director requirements dictates that internal audit

    should report directly to the audit committee of the board of directors rather than the financial vice

    president.

    e. You noted that all management authority seems to reside with three brothers, who serve as

    chief executive officer, president, and financial vice president.

     PROBLEM: The dominance of an organization's management by one or a few individuals is an

    aspect of management's philosophy and operating style that might indicate a problem with the

    internal environment, in that there may be a potential for this small group to override the internal

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    control system. Just because a family is run by family members does not indicate there is a problem

    such as fraud but it does make it easier to commit and that should be take into consideration.

     SOLUTION: It is important to evaluate carefully this situation to determine if it indeed presents an

    internal control weakness.

    f. You were told that the performance of division and department managers is evaluated on a

    subjective basis, because Go-Go’s management believes that formal performance evaluation

    procedures are counterproductive.

     PROBLEM: This indicates a possible problem with management's human resource standards and

    their methods of monitoring performance. Subjective evaluation methods are often not be as

    effective in detecting problems or in identifying good performance as objective measures, such as

    formal performance evaluation procedures, that have been communicated to employees.

     SOLUTION: It is important to evaluate carefully this situation to determine if it indeed presents an

    internal control weakness.

    g. You learned that the company has reported increases in earnings per share for each of the past

    25 quarters; however, earnings during the current quarter have leveled off and may decline.

     PROBLEM: Management's philosophy and operating style, as well as their commitment to integrity

    and ethical values, can be tested when a company faces declining earnings. When earnings per share

    decrease or when they do not meet expectations, company stock can take a dive, sometimes a

    significant one. As a result, a company may try and avoid earnings decreases when possible. The

    problem comes when management uses questionable or even illegal means to prop up their earnings.

     SOLUTION: Because many frauds have been perpetrated to prop up earnings, this significant fraud

    “red flag” must be investigated.

    h. You reviewed the company’s policy and procedures manual, which listed policies for dealing

    with customers, vendors, and employees.

     PROBLEM: One of the methods of assigning authority and responsibility is a written and

    comprehensive policies and procedures manual. Go-Go has a written policy and procedures manual,

    but it is incomplete. It is limited to only three areas: policies for dealing with customers, vendors,

    and employees.

     SOLUTION: A policies and procedures manual should contain much more than what is indicated.

    The manual should explain proper business practices, describe the knowledge and experience needed

    by key personnel, and list the resources provided to carry out specific duties. It should spell out

    management policy with respect to handling specific transactions and documents and the systems

    and procedures employed to process those transactions. It includes the organization’s chart of

    accounts and sample copies of forms and documents. The manual should be a helpful on-the-job

    reference for employees and a useful tool in training new employees.

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    i. Your preliminary assessment is that the accounting systems are well designed and that they

    employ effective internal control procedures.

     PROBLEM: Even though you believe that the accounting systems are well designed, and that they

    employ effective internal control procedures, you cannot rely on that belief. The most effective

    internal control systems and procedures can be negated by a weak internal control environment, such

    as top management overriding the internal controls. In other words, there is no evidence that the

    controls are effective or that employees use and follow them.

     SOLUTION: You cannot rely on the internal controls procedures being effective until you test the

    controls.

    o. You observe that company purchasing agents wear clothing and exhibit other paraphernalia

    from major vendors. The purchasing department manager proudly displays a picture of

    himself holding a big fish on the deck of a luxury fishing boat that has the logo of a major Go-

    Go vendor painted on its wheelhouse.

     PROBLEM: Gifts from vendors can unduly influence purchasing agents to buy more goods from

    the gifting vendors. Purchasing decision should be free of this sort of bias.

     SOLUTION: Part of management’s philosophy and operating style should be the creation of an

    organizational culture that stresses integrity and commitment to ethical values and competence. In

    doing so, management should develop clearly stated human resource standards and policies that

    explicitly describe honest and dishonest behaviors, often in the form of a written code of conduct

    (methods of assigning authority and responsibility), and communicate them to employees.

     These policies should especially cover issues that are uncertain or unclear, such as conflicts of

    interest and the acceptance of gifts. For example, most purchasing agents would agree that

    accepting a $5,000 bribe from a supplier is dishonest, but a weekend fishing trip or clothing is not as

    clear-cut. The observations in the purchasing department indicated that there could be a problem

    with favoring certain vendors.

    P7.2 Explain how the principle of separation of duties is violated in each of the following situations. Also, suggest one or more procedures to reduce the risk and exposure highlighted in each example.

     a. A payroll clerk recorded a 40-hour workweek for an employee who had quit the previous week.

    He then prepared a paycheck for this employee, forged her signature, and cashed the check.

     PROBLEM: Segregation of duties is violated here because the payroll clerk had the ability to

    record time worked and to prepare the payroll check (custody). This allowed the payroll clerk to

    both commit and conceal the fraud. The payroll clerk ignored the authorization process or had the

    authority to authorize the payment.

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     SOLUTION: These three functions should be segregated. One person should authorize payments,

    another should record the payments, a third should prepare the check, and a fourth should sign it.

    b. While opening the mail, a cashier set aside, and subsequently cashed, two checks payable to

    the company on account.

     PROBLEM: The cashier who opened the mail had custody of the cash. The cashier opening the

    mail can pocket the checks and forge a signature, never giving the authorized endorser a chance to

    be involved. For this reason, many companies have the mail opened by two people or have those

    opening the mail videotaped.

     SOLUTION: While the cashier can get away with this fraud for a few weeks or months, the

    missing checks will eventually be noticed usually when the customer complains because the

    cashier has no way to conceal the fraud (recording function). An investigation would include an

    examination of the stolen checks and that could lead to the cashier as the person cashing the checks.

    To be successful in the long term, the cashier needs access to the recording function to indicate that

    customer accounts are paid so that their complaints do not start an investigation.

c. A cashier prepared a fictitious invoice from a company using his brother-in-law’s name. He

    wrote a check in payment of the invoice, which the brother-in-law later cashed.

     PROBLEM: Segregation of duties is violated here because the cashier had the ability to both write

    the check (custody) and approve the invoice for payment (authorization).

     SOLUTION: The functions of authorizing invoices for payment and preparing checks for signature

    should be organizationally independent.

    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 physical

    inventory (custody) and to inventory records (recording).

    SOLUTION: This can be prevented by restricting storeroom access to authorized employees.

    Likewise, access to inventory records should be limited to authorized employees. Where possible,

    no storeroom employee should have access to both the physical inventory and the inventory records.

    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 (recording) to

    the accounts receivable ledger.

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     SOLUTION: Custody of the checks and posting to the Accounts Receivable Ledger should be

    organizationally independent. In addition, there should be an independent reconciliation of the three

    items:

    1. dollar amounts of the checks received

    2. dollar amounts of the checks deposited in the bank

    3. dollar amounts credited to customer accounts.

    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 to record the returns, but did

    not do so to cover the theft.

    SOLUTION: All purchase returns should be documented by preparing a customer receipt and

    recording the return in a purchase returns journal. No cash or credit can be given without the return

    being authorized by a supervisor and recorded in the data files recorded in the cash register.

    The purchase returns area should be kept clean and orderly so that returns cannot be "hid" among

    excess returns. Employees should not be allowed to have gym bags or other personal items that

    could conceal stolen items in work areas.

    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. Apparently, the adjuster also

    had some recording duties (maintaining the vendor master file).

     SOLUTION: The functions of signing checks for invoices, approving vendors, and maintaining the

    vendor master file should be organizationally independent. Payments should not be made to anyone

    that is not on the approved vendor list. Controls should be put into place to endure that employees

    cannot add an unauthorized or unapproved vendor to the vendor master file.

    P7.4 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

    d. Prepare checks for signature

    e. Maintain the cash disbursements journal

    f. Issue credits on returns and allowances

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