Question

FOLEO FONES CASE STUDY – Chapter 9:

Assume you are the management accountant for the Foleo Group & Tracey Chen has asked you to assist her in assessing the organisation’s internal control environment before her meeting with Peter Singh next week. Specifically, she asks you to look at the Foleo Fones & Foleo Accessories Business Units. Tracey provides you with her detailed observations of their current control environments below, & asks for your input.

Foleo Fones & Accessories:

Allan Raymond & Robyn Smith walked me though the controls currently in place for the warehouse, the production plants & the sales offices of Foleo Fones & Foleo Accessories.

The warehouse: The primary risk for the warehouse operation is theft, so control over Foleo’s inventory assets (i.e. raw materials, work in progress & finished goods) is critical. Currently there are no restrictions on entry to the warehouse – it would seem that any employee (or non-employee) can enter the area without authorisation. This needs to be addressed, as the inventory items themselves are not secured behind physical locks or barriers, rather they are accessible to anyone who enters the warehouse. There are controls over the purchasing & receiving functions of raw materials & other miscellaneous items required by the businesses. These consist of authorised purchase orders, receiving inspections & reports, & the recording of materials received into the computerised inventory system. Whilst in theory these controls seem adequate, however, in practice, they are not as effective as they could be, due to staff overriding them at peak times of activity (e.g. when a number of orders are being delivered at the same time). Allan will address this & report back to me. The warehouse manager expressed some concerns about the involvement of Phil Brown, the senior accountant, in the receiving processes of deliveries received. According to the manager, there are staff allocated in the warehouse specifically for this function, & he found it disruptive & unnecessary to have Phil involved with warehouse operations. This will need further investigation. I discussed the incidence of theft over the past six months with the warehouse manager, who advised that there had been an observable increase – he did not have any evidence or numbers to support this observation. Allan will look into this matter & report back to me.

The production plants: The control issues of concern for the plants revolve around the risks associated with not meeting customer demand & escalating costs. These risks have not been sufficiently mitigated, with the plants regularly experiencing issues such as: insufficient raw materials & capacity available for scheduled production runs; unplanned production downtime due to machinery breakdowns & staffing issues; reworking of defective phones & accessories; cost blowouts in direct labour & materials; cost increases associated with expediting late orders; etc. Allan & Robyn have introduced some controls to address these issues, however it does not appear that they are being sufficiently monitored or enforced. Monthly variance reports are generated, but not regularly reviewed by the Business Unit Managers due apparently, to their time constraints. H.O. do not see these reports, nor do we hear about them from the Business Managers. This will need to be addressed. Quality assurance activities are in place for the raw materials, products during the manufacturing process & finished goods. These activities were introduced as a result of Foleo’s focus on delivering quality to our customer some months ago, however it is evident that controls over the operations of these activities need to be enforced to eliminate the risk of poor quality goods being produced & supplied to our customers.

The sales offices: The risk most evident for the sales function of Foleo Fones & Accessories is that of revenue streaming. There are currently budgets in place, along with performance targets for sales staff, however, in the past these have encouraged the deferral of sales once the targets have been achieved. The Balanced Scorecard will hopefully address this sort of behaviour, however the Business Unit Managers need to monitor the budgets & actual results more carefully to identify potential instances of revenue streaming. Another more sinister risk for the area of sales is that of bogus customers & fraud. Both Foleo Fones & Accessories have in place an authorised customer list on their sales system, so that sales can only be entered against customers already in the system. Allan & Robyn have recently introduced a formalised process for adding new customers onto their authorised lists that involve multiple trade & credit checks. My suggestion would be that an ASIC check should be added to this process & that this authorisation process should be restricted to the Sales Managers.

1. Based on Tracey’s observations as well as the week’s readings and lecture materials, identify five (5) lapses in the control environments of Foleo Fones and Foleo Accessories, and explain the risks that each presents.                                                                              

(HINT: Ensure you identify the controls that might be missing and explain the implications for the organisation of EACH missing control.)         (1.5 marks)

2. Define preventive and detective controls. Suggest a specific control that Allan Williams and Robyn Smith might introduce to address each of the lapses you identified in part (a) and classify each control suggestion as either preventive or detective in nature. Explain your choice of classifications.      (1.2 marks)

3. Select three (3) controls you have suggested in part (b), and describe how each will work towards achieving the overarching objectives of the Foleo organisation.                                                                                                                                    (0.6 mark)

(HINT: You may need to revisit the entire Foleo Case Study and/or the exercises you have completed so far to refresh your memory of the overarching objectives of the organisation.)

(HINT: Ensure you identify and explain the specific objective that each control will relate to.)

4. What are the four levers of control? For the three (3) of the controls you selected in part (c), classify each as one of the levers of control and explain why.

(HINT: Refer to the Simons reading for information on the levers of control.)                                      (0.7 mark)

Answer 1

Answer:-

A.

1.    Any employee can enter the warehouse - this control deficiency poses a risk to the physical security of inventory. Unauthorized entry of employee or non-employee may result to theft.

2.    Staff can override controls on purchase orders, receiving inspections & reports, & the recording of materials received into the computerised inventory system - this shows a risk on fraud, particularly misappropriation of assets. A received shipment may not be reported and may be stolen if the employees can override controls. Controls, no matter how designed, when not implemented and monitored effectively, will fail to mitigate the risks. Ineffective controls give opportunities to employees to commit fraud.

3.    Phil Brown's involvement in the receiving process - there is a risk on the proper segregation of duties on this case. The tasks of being a Senior Accountant who is responsible for the recording functions is in conflict with being involved in the receiving process which is a custodial function. A violation on the rules of segregation of duties pose a risk to different kinds of fraud such as misappropriation of assets and fraudulent financial reporting.

4.    Monthly variance reports not regularly reviewed and used - this poses a risk to operational efficiency. When the causes or roots of unfavorable variances are not being investigated and paid attention to, this may lead to higher costs in production and poor decision making in terms of operations.

5.    Deferral of reporting of sales - weak control on this places the Company in a business risk of not being able to realize its revenues to its full potential. The Company loses its opportunity to earn higher revenues because of the quota set which becomes the limit. It could have outperformed the target sales but the employees opt to defer the reporting of these sales.

B.

The controls designed to prevent an error before it occurs are preventive while controls designed to catch errors after occurrence are detective controls. Segregation of duties are best example of preventive control and reconciliation or review of operational activities are detective controls.

1.    Any employee can enter the warehouse

Control (Preventive): Limit access to warehouse. Have visitors sign in and out when arriving and leaving the building. Processes should be implemented to register and account for all non-company individuals on site. Visitors should always be escorted by authorized personnel—no exceptions. Nobody external to facility staff (including employees of the customer who owns the inventory) should be allowed access inventory storage areas without being escorted and having written authorization from the supply chain services provider requested in advance. This is a preventive control because it establishes measures to avoid theft.

2.    Staff can override controls on purchase orders, receiving inspections & reports, & the recording of materials received into the computerised inventory

Control (Preventive): Limit access rights by role on the inventory system. Assign access and permission levels to purchase order approval, receiving inspections and recording on inventory system, as necessary to the roles. No one should have permission to approve his own orders. No one should receive the inventory and also have him record it on the system. It should also be considered to audit the lists of authorized users for all systems at least quarterly to ensure that access rights line up with current roles. This control is preventive since the misconduct is being prevented from happening through limiting the access rights on the system depending on the employee's role.

3.    Phil Brown's involvement in the receiving

Control (Preventive): Segregate the duties. One of the easiest and most essential safeguards is to separate duties to create oversight. This makes it more difficult for someone to both commit and cover up fraud. No one should have any two of the following duties: custody, authorization and recording. This is preventive since the risk of fraud is being mitigated before it actually happens.

4.    Monthly variance reports not regularly reviewed and used

Control (Detective) - Require the review of variance analysis and a regular reporting of management action plans. Variance analysis is important to assist with managing budgets by controlling budgeted versus actual costs. Business Unit Managers (BUM) should pay attention to these reports because these partly show how they perform. By doing these, BUM will be able to identify the root cause of inefficient operations and pay attention to the possible action plans in order to deal with the matter. This is a detective control because it helps the management identify and address the cause of problems after they happened.

5.    Deferral of reporting of sales

Control (Detective) - Regular and spot audit of sales and activities, particularly the cutoff. A simple matching of actual sales date and sales recording date will reveal sales that are intentionally deferred in reporting. It may also help to establish a table of sanctions for the violators in order to get rid of dishonest sales employees. This is a detective control because it merely helps the Company identify the violators.

C.

1.    Segregate the duties - "We aim to provide a working environment for our employees that encourages and facilitates a happy and motivated team." When duties of each employee are well-defined and in the right scope, it will promote a harmonious working environment amongst different divisions of the Company as responsibilities will be in sync and not conflicting.

2.    Regular and spot audit of sales - "We aim to grow each business by at least 8 per cent per annum over the next decade" This control will help the Company realize its full potential in terms of generating sales by having it outperform its target when the dishonest sales personnel are hindered from streaming the Company's sales. It will also give a renewed sense of motivation to employees to reach another set of target sales when there are no "reserved" or "deferred" sales being kept for reporting.

3.    Require the review of variance analysis and a regular reporting of management action plans - "We aim to use and provide the most up-to-date technology available to ensure our customers receive the best product possible at the lowest price." When the variance reports are properly prepared and utilized, it will help the management identify causes of inefficiencies and address these to drive down costs by proposing improvements and efficiency measures on the production.

D.

Simons proposed four levers of control:

1. Belief systems, used to inspire and direct the search for new opportunities;

2. Boundary systems, used to set limits on opportunity-seeking behavior;

3. Diagnostic control systems, used to monitor and reward achievement of specified goals; and

4. Interactive control systems, used to stimulate organizational learning and the emergence of new ideas and strategies.

1.    Segregate the duties - BOUNDARY SYSTEMS. This is considered a boundary system control because it creates constraints and limiting actions of employees to the duties imposed on them.

2.    Regular and spot audit of sales - DIAGNOSTIC CONTROL SYSTEM. This is a diagnostic control system because the performance is being reviewed or audited to determine compliance with established rules such as faithful reporting of sales.

3.    Require the review of variance analysis and a regular reporting of management action plans - DIAGNOSTIC CONTROL SYSTEM. This is a diagnostic control system because it monitors the compliance of results and behavior (actual) against the strategies (budget), of a company. Thus, they drive the right behaviors in the business in a fashion that allows self-correction.