Question

CASE 2

Mark Hobson is an internal auditor employed by Com­ stock Industries. He is nearing completion of an audit of the Avil Division conducted during the first five weeks of the year. The Avil Division is one of three manufacturing divisions in Comstock and manufactures inventories to supply about 50 percent of Comstock's sales. In addition to the manufacturing divisions, Comstock has two marketing divisions (domestic and international) and a technical service division that offers worldwide technical support. Each customer is assigned to the most suitable manufacturing division, which functions as the supplier for that customer. The manufacturing division then approves the customer's credit, ships against orders obtained by the sales representatives, and collects the customer receivables when due. This allows order-to-order monitoring of customer credit limits against customer orders received.

Two Potential Observations

Two items concern Mark. First, there was a material dollar amount of inventory of part number A2 still carried on the Avil books at year-end, despite the fact that the Fast-tac machining component in which part A2 was used is now considered the first generation and is no longer manufactured. Company policy requires an immediate write-off of all obsolete inventory items. Second, some accounts receivable still carried as collectible at year-end were more than 180 days old. All receivables are due in 30 days, which is standard for the industry. Mark believes many of these old accounts are uncollectible.

The division manager's administrative assistant, Brenda Wilson, performed the aging- of accounts receivable rather than the division accountant, as is standard practice. The division accountant refused to discuss the circumstances of Brenda's actions.

The Auditee's Comments

Mark scheduled a meeting with Brenda to discuss his concerns.

"Well, Mark," Brenda responded, "I know that policy requires that obsolete inventories be written off; but part A2 is just not being used at present. We might start to make those Fast-tac components again. Who knows? Wide ties are coming back again, aren't they? Fast-tac could, too. There are plenty of customers, especially in the third world, that are finding those second- and third-generation machines pretty expensive to maintain. I mean, there is a policy that states obsolete inventories should be written off, but there is no policy defining an obsolete part."

"And as for those receivables,” Brenda continued, "that is certainly a judgment call, too. Who knows if those accounts will be collected? We're in a slight recession now. When things pick up, we'll probably collect a few. There isn't even a policy in this division on writing off receivables. I checked. Nothing says I have to write them off. So who are you to say I have to?"

“'Brenda, be straight. You know those parts will never be used. And you know those receivables are bad."

"Look, Mark," Brenda finally bargained, "it's only two weeks from the close of the year. Let's let these items ride till after the close so that everyone gets their bonuses. Then, I promise I'll take a fresh look at both inventories and receivables. I'll write them down after year-end after the financial reports are issued. No one will know. And, after all, who's to be hurt?"

The Division Manager

Mark continued his audit, drafted his report containing observations related to the inventory and receivables, and reviewed the report with the division manager, Hal Wright. Hal was visibly disturbed.  

"Gee, Mark, this couldn't have come at a more awkward time. Our figures just passed muster by the independent outside auditors. There was a guy out here for our inventory count in November, and Brenda already sent her spreadsheet on year-end receivables to corporate head­ quarters. No one up there, in our group or on the CPA audit team, was the least bit critical. If you go raising a big stink, particularly now, the independent outside auditors will catch us writing off inventory and receivables, they'll adjust profit, and there will be hell to pay for all of us. And, Mark, this is no clear-cut issue either. I mean, I can see how you can write a report calling for clearer policy, but not one calling for specific write-downs. That's way out of your jurisdiction. But still, I promise, we'll look at all this after our statements go to bed. Right now, I feel the managers of this division have worked their hearts out and I intend to fight to protect what little bonuses they have coming. If we write down as you suggest, those bonuses will go and the stockholders will lose too. Earnings per share (EPS) will drop like a rock. They might even close this division. Now you don't want that, do you, boy?"  

"Well, Hal, I could word my observations as they are in the draft but include your response." Hal was suddenly angry. "What? And let the audit committee decide the issue? They have nothing to do with this. They accepted the CPA’s report. If you want to make the audit committee happy, you'll accept it, too, and leave this adjustment stuff alone."

The Internal Audit Director
Concerned, Mark delayed finalizing his report and discussed the draft with Gail Wu, director of internal audit. Gail is not trained as an auditor and was promoted to director of internal audit from corporate finance so that she might develop a better understanding of operating relationships. Still, Gail is very smart and Mark has always respected her opinion. The discussion was by telephone, with Mark still at the Avil Division headquarters and Gail at the corporate office.

"Mark, Hal is right. If you, in essence, blow the whistle on management bonuses this year, we can kiss goodbye all the goodwill I've been struggling to build for this department. It will all go out the window."

"I know you've been trying to put us on a better footing, Gail, but Hal is intractable. As far as he is concerned, the only observation he will accept in the report is that of deficient policy, with nothing mentioned about the inventory or receivables needing adjustment."

"Well, do what you have to," Gail ended the discussion. "But I insist that you submit a report that Hal agrees to and has signed. I don't want to stir up hornets and then have to try to explain my loose cannon to the board when everyone is howling about the bonus problem."

1. Refer to The IIA’s Code of Ethics. Identify three specific Rules of Conduct relevant to this case.
2. Using the Rules of Conduct you identify as the context, discuss the ethical issues raised in the case.
3. Discuss how the ethical dilemma Mark faces might have been avoided. In other words, discuss specific things Comstock's management and/or the internal audit function might have done to reduce the risk of such a situation arising.
4. Clearly indicate what you would do if you found yourself in Mark's position. Briefly explain why.

Answer 1

Answer = The three specific Rules of conduct are as follows 1= Integrity, 2 = Competency, 3= Objectivity.

Ethical Issues Raised in the case - Based on above three rules of conduct, the ethical issues being raised in the case is that the internal auditor should swear by IIA Code of Ethics. The internal auditor should be competent enough to observe the situation and as per law make the observation, his/her onservation while audit of operations should not be baised and it should align with audit standards and accounting policies. The internal Auditor shall not knowingly be a party to any illegal activity, or engage in acts that are discreditable to the profession of internal auditing or to the organization. He shall respect and contribute to the legitimate and ethical objectives of the organization. As you have observed in the case that how the Division Manager & Internal audit director asking the internal auditor Marrk to make favourable changes in his audit observation so that their motives of getting high earning per share, disclosure of less profit and high amount of bonuses could be fulfilled.

Steps to avoid the the situation which has ben observed in the above case - The company should have proper accounting policies for the accounting treatment of every material item present in the books of account. As Brenda gave an excuses that since the company didn't have policy for writting off the account recievables and also company have policy to write off the obsolete part but it has no policy/ guidelines on how and on what determinants obsolency of Raw material will be decided. Hence she was able to outsmart the situation clearly only because company lack proper formullation and implementation of accounting policies.

What would have you done if you were to be at Mark's Position - Had you been in the situation, you would have also did what mark did as an internal auditor as he very deligently made each and every observation and as per the SOP before making a final Audit Report, he asked for an valid explanation for the findings he observed and expected to make required adjustments as required by accounting policies but the concerned authority( Brenda, Division Manager ) was seem reluctant to it in order to fulfill their baised motives. And as far as final audit report is concerned, had you been in that situation you should clearly make your observations of account recievables and obsolete part based on your true findings irrespective of the disagreements you have recieved.

Note - since this question is subjective, its answer can have multiple sub points based on the audit observation but the basic crux behind this question is the three basic rules of conduct as per IIA'S CODE of ethics and that is INTEGRITY, OBJECTIVITY, COMPETENCE.

I hope you have got the answer, in case of any doubt, Please let me know in the comment section :)