Question

Internal controls play an integral role in developing reliable financial records that facilitates the decision-making process. Further, a well-designed internal control system helps in preventing or detecting errors and fraud. Realising the importance of internal controls, the internal auditing department of Dynamic Sportswear periodically reviews the accounting records of the company to determine the effectiveness of the internal controls. During the latest review, the internal audit department found the following conditions:

1. There are occasional discrepancies between the daily bank deposits and the cash receipts. [1 Mark]

2. One employee is preparing and approving the bad debt write-offs. [1 Mark]

3. There are also occasional discrepancies between physical inventory counts and perpetual inventory records. Furthermore, alterations have been made to the physical inventory counts and to the perpetual inventory records. [3 Mark]

4. The customer's records reveal that there are many customer refunds and credits. [1 Mark]

5. Many original documents are missing or lost. However, there are substitute copies of all missing originals. [2 Mark]

6. There is a substantial decrease in the gross profit percentage. This decrease is not explained. [2 Mark]

7. Many documents are not approved. [1 Mark]

Required: Describe the possible reasons for these identified conditions above (from 1. – 7.) and recommend effective internal control(s) for each condition.(upto 400 words )

Answer 1

Internal controls are the mechanisms, rules, and procedures implemented by a company to ensure the integrity of financial and accounting information, promote accountability, and prevent fraud. Besides complying with laws and regulations and preventing employees from stealing assets or committing fraud, internal controls can help improve operational efficiency by improving the accuracy and timeliness of financial reporting.

Internal Audit is a department or an organization of people within a company that is tasked with providing unbiased, independent reviews of systems, business organizations, and processes. The role of Internal Audit is to provide senior leaders and governing bodies of an organization an objective source of information regarding the organization’s risks, control environment, operational effectiveness, and compliance with applicable laws and regulations.

Possible reasons for these identified conditions are as follows:

1. There are occasional discrepancies between the daily bank deposits and the cash receipts.

· Outstanding Checks

· Deposit in transit

· Bank service charges and check printing charges

· Errors on the company's books

· Electronic charges and deposits that appear on the bank statement but are not yet recorded in the company's records

2. One employee is preparing and approving the bad debt write-offs

Uncollectible customer accounts can be written off for a number of reasons, including the inability to locate the debtor and discharge of the debt in a bankruptcy. A company might decide that efforts to collect the debt are no longer cost effective. The collections department must comply with the collection efforts outlined in the policy to collect on delinquent customer accounts before any write-offs are made.

A bad debt policy may include the approval requirements that are necessary to write off customer accounts depending on their dollar value. For example, a bad debt policy may allow a low-level manager to approve customer write-offs that range between $1,500 and $5,000, a midlevel manager to approve write-offs that range between $5,000 and $10,000 and a corporate director to write off accounts that exceed $10,000.

Staff are required to take robust action to collect all debts; however, in some cases, this might not be possible and debts do become irrecoverable. Where a debt is deemed to be non-recoverable (or a credit non-refundable), it needs to be identified at the earliest possible opportunity and properly dealt with in accordance with financial regulations. Irrecoverable debts must also be identified and written off promptly; if only because they are shown in the council’s accounts as an asset.

There are four levels of write off:-

• For debts up to but not exceeding £100 (including aggregated debts for one debtor), the delegated authority rests with the enforcement team leader.

• For debts greater than £100 but not exceeding £1,000 (including aggregated debts for one debtor), the delegated authority rests with the authority’s partnership manager.

• For debts greater than £1,000 but not exceeding £10,000 (including aggregated debts for one debtor) (and for all credit balances), the delegated authority rests with the senior partnership manager.

• For debts greater than £10,000 (including aggregated debts for one debtor), the request for write-off must be made in a report to the executive.

3. There are also occasional discrepancies between physical inventory counts and perpetual inventory records. Furthermore, alterations have been made to the physical inventory counts and to the perpetual inventory records.

The periodic system uses an occasional physical count to measure the level of inventory and the cost of goods sold (COGS). Merchandise purchases are recorded in the purchases account. The inventory account and the cost of goods sold account are updated at the end of a set period—this could be once a month, once a quarter, or once a year. Cost of goods sold is an important accounting metric, which, when subtracted from revenue, shows a company's gross margin.

By contrast, the perpetual system keeps track of inventory balances continuously, with updates made automatically whenever a product is received or sold. Purchases and returns are immediately recorded in the inventory account. As long as there is no theft or damage, the inventory account balance should be accurate. The cost of goods sold account is also updated continuously as each sale is made. Perpetual inventory systems use digital technology to track inventory in real time using updates sent electronically to central databases.

Periodic inventory accounting systems are normally better suited to small businesses due to the expense of acquiring the technology and staff to support a perpetual system. A business, such as a car dealership or art gallery, might be better suited to the periodic system due to the low sales volume and the relative ease of tracking inventory manually.

However, the lack of accurate information about the cost of goods sold or inventory balances during the periods when there has been no recent physical inventory count could hinder business decisions.

Unauthorized access to physical inventory and/or inventory records.
Inventory theft by employees.

Reason for Alterations to physical inventory counts and perpetual inventory records is Unauthorized access to inventory records and Fraud.

Under the perpetual system, managers are able to make the appropriate timing of purchases with a clear knowledge of the quantity of goods on hand at various locations. Having more accurate tracking of inventory levels also provides a better way of monitoring problems such as theft.

4. The customer's records reveal that there are many customer refunds and credits.

Collusion among customers, salespersons, common carriers, and the shipping and accounting departments of Covington.
Poor product quality

5. Many original documents are missing or lost. However, there are substitute copies of all missing originals

Failure to use pre-numbered documents.
Fraud was perpetrated, original copies of the documents were destroyed, and they were replaced by photocopies

6. There is a substantial decrease in the gross profit percentage. This decrease is not explained.

Granting unauthorized discounts or credits to customers.
Theft of inventory

Customers given lower, preferential sales price

Unrecorded sales

7. Many documents are not approved.

Lack of, misunderstanding of, or failure to comply with written procedures.

Fraud committed by bypassing the approval process

Recommended effective internal control(s) for each condition are as follows:

1. There are occasional discrepancies between the daily bank deposits and the cash receipts.

Payments received later are almost always in the form of checks. Stores prepare a record of the checks received as soon as they are received. Some merchandising companies have customers send the payments directly to the bank instead of the company itself. Although businesses vary their specific procedures for controlling cash receipts, they usually observe the following internal control techniques:

· Prepare a record of all cash receipts as soon as cash is received. Most thefts of cash occur before a record is made of the receipt. Once a record is made, it is easier to trace a theft.

· Deposit all cash receipts intact as soon as feasible, preferably on the day they are received or on the next business day. Undeposited cash is more susceptible to misappropriation.

· Arrange duties so that the employee who handles cash receipts does not record the receipts in the accounting records. This control feature follows the general principle of segregation of duties given earlier in the chapter, as does the next principle.

· Arrange duties so that the employee who receives the cash does not disburse the cash. This control measure is possible in all but the smallest companies.

Companies also need controls over cash disbursements. Since a company spends most of its cash by check, many of the internal controls for cash disbursements deal with checks and authorizations for cash payments. The basic principle of segregation of duties also applies in controlling cash disbursements. Following are some basic control procedures for cash disbursements:

· Make all disbursements by check or from petty cash. Obtain proper approval for all disbursements and create a permanent record of each disbursement. Many retail stores make refunds for returned merchandise from the cash register. When this practice is followed, clerks should have refund tickets approved by a supervisor before refunding cash.

· Require all checks to be serially numbered and limit access to checks to employees authorized to write checks.

· Require two signatures on each check over a material amount so that one person cannot withdraw funds from the bank account.

· Arrange duties so that the employee who authorizes payment of a bill does not sign checks. Otherwise, the checks could be written to friends in payment of fictitious invoices.

· Require approved documents to support all checks issued.

2. One employee is preparing and approving the bad debt write-offs

Both internal and external audit need to be satisfied any write off policy is both robust and transparent. At the same time, there needs to be a mechanism for reporting write offs through to members. A debt should only ever be written off in accordance with the policy agreed my members.

The Company should review its segregation of duties policies and procedures, along with compensation arrangements, surrounding the service cancellation, billing credit, and bad debt write-off areas. Processes should be designed to ensure Company personnel associated with these areas are independent of customer sales and provisioning. Compensation arrangements that could impede proper accounting controls should be reviewed. Specific instances were identified by Company personnel .

The Company maintains policies requiring sales department authorization for the issuance of significant billing adjustments and the write-off of significant aged receivables, which directly impact sales team bonuses.

3. There are also occasional discrepancies between physical inventory counts and perpetual inventory records. Furthermore, alterations have been made to the physical inventory counts and to the perpetual inventory records.

For occasional discrepancies

Limit physical and logical access to the inventory records to authorized employees.
Require that all adjustments to inventory records be approved by a responsible official.

Count all inventory when received at the warehouse and at the storeroom; reconcile the counts.

Count inventory to be shipped before it is removed from the storeroom, when received by shipping, and when shipped; reconcile counts.
Bar codes and RFID tags to facilitate counts
Hold storeroom employees responsible for all inventory losses.

For alterations

Limit physical and logical access to the inventory records to authorized employees.
Require that all adjustments to inventory records be approved by a responsible official.
Examine physical inventory counts and perpetual inventory records for evidence of fraud
Terminate any employees that commit fraud

4. The customer's records reveal that there are many customer refunds and credits.

Segregate duties so refunds and credits are authorized by responsible employees not otherwise involved in sales, shipping, or maintaining accounts receivable.

Fix production problems

5. Many original documents are missing or lost. However, there are substitute copies of all missing originals

Use pre-numbered documents to facilitate the control and identification of documents.

Investigate all instances where originals are missing and photocopies are used.

6. There is a substantial decrease in the gross profit percentage. This decrease is not explained.

Require the approval of a responsible party before granting customer discounts or credits.

Count all inventory when received at the warehouse and at the storeroom; reconcile the counts.

Count inventory to be shipped before it is removed from the storeroom, when received by shipping, and when shipped; reconcile counts.

Bar codes and RFID tags to facilitate counts

Hold storeroom employees responsible for all inventory losses.
Require the approval of a responsible party before granting preferential sales prices
Require the use of pre-numbered sales documents and do not allow inventory to leave the warehouse without an accompanying sales document.

7. Many documents are not approved.

repair or update written procedures and train employees using the procedures

Hold employees responsible for not approving documents
Examine unapproved documents for evidence of fraud
Terminate any employees that commit fraud.