Question

The SB Construction Company has two divisions. The president, Su, manages the roofing division. Su has delegated authority and responsibility for management of the modular manufacturing division to Jon Gee. The company has a competent accounting staff and a full-time internal auditor. Unlike Su, however, Gee and his secretary handle all the bids for manufacturing jobs, purchase all the materials without competitive bids, control the physical inventory of materials, contract for shipping, supervise the construction work, bill the customers, approve all bid changes, and collect the payment from customers. With Su’s tacit approval, Gee has asked the internal auditor not to interfere with his busy schedule.

 

Required:

a. Discuss the internal control in this fact situation and identify fraud risks that could arise.

b. Assume you are the independent external auditor of SB. Explain your responsibilities to report on this situation to SB’s management and board of directors.

Answer 1

 a & b.

The discussion could take several directions, including some or all of the following:

1.   Material Weakness. The facts seem to suggest "a condition in which specific control features (few or none are described) or the degree of compliance with them do not reduce to a relatively low level the risk that errors or fraud in amounts that could be material to the financial statements may occur and not be detected within a timely period by employees in the normal course of performing their assigned functions." Gee has authority and influence over too many interrelated activities. Nothing he does seem to be subject to review or supervision. He even is able to exclude the internal auditor.

 

An identification of the potential irregularities will illustrate the misdeeds he can perpetrate almost single-handedly.

 

2.   Potential irregularities include:

a.   Gee can collude with customers to rig low bids and take kickbacks, thereby depriving the company of legitimate revenue.

b.   Gee can direct purchases to favored suppliers, pay unnecessarily high prices and take kickbacks. He might even set up a controlled dummy company to sell overpriced materials to the company. No competitive bidding control prevents these activities.

c.   Gee, through the control of physical inventory, can (i) remove materials for him, and (ii) manipulate the inventory accounts to conceal shortages.

d.   Gee can order truck shipping services for his own purposes and cause the charges to be paid by the company.

e.   Gee can manipulate the customer billing (similar to a above) to deprive the company of legitimate revenue while taking an unauthorized commission or kickback.

 

3.   Almost every desirable characteristic of good internal control has been circumvented:

a.   Segregation of Functional Responsibilities. Gee has authorization and custodial responsibilities.

b.   Authorization, Supervision. Gee is apparently subject to no supervision or review. The accounting staff is probably powerless to challenge transactions because of Su's apparent approval of Gee's powers.

c.   Controlled Access. The whole situation gives Gee access to necessary papers, records, and assets to carry out his one-man show.

 

d.   Periodic Comparison. No one else apparently has any access to the materials inventory in order to conduct an actual count for comparison to the book value (recorded accountability) of the inventory.