Question

In regards to cash and inventory, what are some "compensating controls" that could have been implemented for this small business (review Ch. 4 for ideas)?

Answer 1

Manysmaller companies might require more time to evaluate their internal control over financial reporting because they lack the formality or structure in their internal control systems that larger companies have.

According to the SEC’s interpretive guidance, compensating controls are defined as follows:

Controls that serve to accomplish the objective of another control that did not function properly, helping to reduce risk to an acceptable level. To have a mitigating effect, the compensating control should operate at a level of precision that would prevent or detect a misstatement that was material.

The SEC states that management should evaluate the effect of compensating controls when evaluating whether a deficiency, or a combination of deficiencies, is a material weakness. For this purpose, the compensating controls must be operating effectively, i.e., there must be evidence that the controls are operating effectively.

Note that compensating controls are not considered when determining whether a control deficiency exists. Control deficiencies must be considered individually and in isolation of the performance of other controls. Compensating controls are appropriately considered when evaluating whether a significant deficiency or a material weakness exists.

Before going into compensating controls that could have been implemented for this small business, it has to be ensured that Responsibility for undertaking financial processes has been shared – with no employee having responsibilities for a whole process alone. This protects everyone in a team and removes the temptation to misuse funds. The separation of duties matrix helps a team to structure this approach.

Cash management – one person opens the envelopes containing checks from trainees attending the courses and a different person records these in the accounting records.

Inventory – one person looks after the stores and record all goods received and issued into an inventory register and another person counts this inventory from time to time and checks that the quantities counted agree to the register.

As informed above, compensating controls are additional to the other internal controls, thus after putting into place the above mentioned internal controls, compensating controls such as independent verifications, reconciliations, or other reviews should occur regularly to mitigate the risk of errors, omissions or irregularities.

Monitoring and review of receipting and disbursement activity by supervisory personnel not directly involved with daily processing could be added as compensating controls.

Suggestions for Best Practices.

Generally one person should be designated as petty cash custodian. This person disburses petty cash and turns in vouchers to have fund reimbursed. Petty cash custodian should not have access to post activity to general ledger or replenish petty cash fund. Petty cash counts should be made on periodic basis by someone independent of petty cash process.

Produce reports of purchase orders and subsequent payments from the accounting system and have a supervisory level employee independent of the purchasing function review the reports for accuracy. Have employee pay particular attention to payments to new vendors. Have person independent of purchasing process check bills of lading and receiving evidence to inventory records.

If physical counts cannot be performed by employee independent of the inventory process, then spot checks of inventory counts should be made by employee who is not custodian of inventory assets or responsible for recording inventory on accounting records.

If unable to adequately separate duties of maintaining inventory system from reconciliation and posting, one suggestion would be to have supervisory personnel receive reports of changes to inventory balances, paying particular attention to manual changes and adjustments. If disposal activities cannot be adequately separated, a supervisory level employee could review and approve a listing of items identified for disposal against actual disposals recorded and income received from scrap sales.