Question

Ajax Company is a large retail company that sells clothing, shoes, and other apparel. It has 40 retail outlets located in 22 states. All of the merchandise if purchased by a centralized procurement organization located at the company’s corporate headquarters. There are six purchasing agents with each agent assigned to purchase different types of goods. Each agent works independently with suppliers to get the best deals for the company. The six agents report to the purchasing director. The director oversees all the activities of department and must approve all orders in excess of $100,000. Otherwise, each agent has authority to conclude his/her own deals. Based on the above:

1. Give an example of a preventive control that should be in place for this department and explain its objective. Give an example of a detective control and explain its objective. Be specific.

Answer 1

SOLUTION

Internal controls are of two types. Preventive controls and detective controls

A. Preventive control:Preventive controls are designed to prevent errors, inaccuracy or fraud before it occurs. Most of preventive controls are foundational /operational in nature such as authorization matrix, delegation of authority, re- verification of invoices before recording entries etc..,

B. Detective controls: Detective controls are designed to identify the errors, inaccuracy or fraud after it has occurred. Most of the detective controls are monitoring in nature such as Monthly review of invoices on sample basis, overall purchases analysis etc..,

In current scenario, all the purchase deals below $100,000 are closed by the six agents as per authority given to them. However, this could result in fraud such as agent making personal profits out of deals.

Eg: Agent may discuss with the supplier to increase the purchase price and may take personal advantage of the same by asking a specific share in the increased price. To not get caught in this fraud, instead of raising one single order for, say $150,000, he may raise six small orders of $25,000 each. These orders are not again verified by any Director, as they are less than $100,000 limit.

Suggested preventive controls:

1. All the orders less than $100,000 should be verified by another agent to check whether the deal finalized by agent is best for company or not.

2. The limit of $100,000 should be reduced to $50,000 for director's review of deals.

3. Quotation analysis should be performed by another agent to ensure best deal is accepted.

Suggested preventive controls:

1. The deals finalized by all agents needs to be verified (from invitation to tender to issuing final PO) by Director on a sample basis at the end of every month.

2. Supplier wise and month wise analysis should be done for each product and trends should be analysed.

3. Purchases analysis (Product wise month wise) should be done to ensure that there is no misstatement of purchases.