Question

Alabama Industries manufactures and wholesales small tools. It sells the tools to a large group of regular customers and makes most sales by telephone to this group. Additionally, it receives orders online by its sales team who signs up new customers within the sales area. In the past, Alabama Industries has had trouble with customers who do not pay their accounts on time. Despite instructing the sales team not to make sales to customers before their creditworthiness has been assessed, sales are still being made to new customers before their limits have been set and to existing customers beyond their credit limit. Also, an economic downturn has started to impact its customers, and Alabama’s management is concerned about the possibility of increasing bad debts.

1a. What sort of preventive control could be used to deal with the problems faced by Alabama Industries? Explain how the control would work.

1b. Assume the preventive control is implemented, and during this year there have been no sales to customers that have taken any customer beyond its credit limit. What are two possible explanations for this that the auditor must consider?

1c. If an auditor finds two sales transactions during the year that exceed a customer’s credit limit at the time of the sale, what conclusion would the auditor draw from this evidence? What other evidence could the auditor consider before concluding that the preventive control has failed?

Answer 1

1a. Prevent controls would be designed to stop sales being made to non-creditworthycustomers. For example, the software would not allow a sale to be made until the credit manager has approved the sale on credit, or the software could require a credit check authorisation number to be included in the sale transaction. The system could require all new customers to be approved before a debtor account can be opened, and the account has to be open before a sale can be processed to that customer. The systemwould prevent a sale being made if the sale took the account balance beyond theapproved credit limit, unless authorised by the credit manager.

1b.The auditor observes that no credit sale has been processed which takes a customer over its credit limit. The two possible explanations are: (1) the preventive control is working effectively; (2) no customer has tried to purchase items which take it over its credit limit. In the second case, there is no evidence that the preventive control is working or not working, because it was not triggered.

1c. The transaction could have been authorized by the credit manager (or other senior manager). The authorization could be because the client has security for the balance owing. However, the authorization could be inappropriate and be a case of management override of the control. That is, the manager may have overridden the preventive control to make a sale for reasons such as receiving a kick-back from the customer, disregard for company policy against such sales, an effort to reach sales targets in the department, etc. The auditor would consider whether there was evidence of higher level authorization of the transactions, such as reading board minutes, reading correspondence or memos between the managers, reading the customer file for evidence of security for the balance due, making enquiries of the relevant sales managers. The auditor would also consider if other similar transactions (same sales manager, same client, same product, etc) are being processed correctly, or if there is evidence of other sales in excess of credit limits being prevented.