Governance - Chapter 16 PDF

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Summary

Chapter 16: INTERNAL CONTROL AFFECTING ASSETSExpected Learning OutcomesAfter studying the chapter, you should be able to ... Describe the internal control over the major components of assets of a business enterprise namely; a. Cash b. Financial Investments c. Receivables: Accounts and Notes are rela...

Description

Chapter 16: INTERNAL CONTROL AFFECTING ASSETS Expected Learning Outcomes After studying the chapter, you should be able to … 1. Describe the internal control over the major components of assets of a business enterprise namely; a. Cash b. Financial Investments c. Receivables: Accounts and Notes are related revenue accounts d. Inventories and related Cost of Goods sold e. Property, Plant and Equipment 2. Understand the potential misstatements (due to errors) of the asset accounts and how weakness in internal control increases the risks of misstatements.

INTERNAL CONTROL OVER CASH TRANSACTIONS Most of the processes relating to cash handling are the responsibility of the finance department, under the director of the treasurer. These processes include handling and depositing cash receipts; signing checks; investing idle cash; and maintaining custody of cash, marketable securities, and other negotiable assets. In addition, the finance department must forecast cash requirements and make both short-term and, long-term financing arrangements. Ideally, the functions of the finance department and the accounting department should be integrated in a manner that provides assurance that: 1. All cash that should have been received was in fact received, recorded accurately and deposited promptly. 2. Cash disbursements have been made for authorized purposes only and have been properly recorded. 3. Cash balances are maintained at adequate, but not excessive, levels by forecasting expected cash receipts and payments related to normal operations. The need for obtaining the loans for investing excess cash is thus made known on a timely basis. A detailed study of the business processes of the company is necessary in developing the most efficient control procedures, but there are some general guidelines to good cash handling practices in all types of business. These guidelines for achieving internal control over cash may be summarized as follows: 1. Do not permit any one employee to handle a transaction from beginning to end. 2. Separate cash handling from record keeping. 3. Centralize receiving of cash to the extent practical.

4. 5. 6. 7.

Record cash receipts on a timely basis. Encourage customers to obtain receipts and observe cash register totals. Deposit cash receipts daily. Make all disbursements by check or electronic fund transfer, with the exception of small expenditures from petty cash. 8. Have monthly bank reconciliation prepared by employees not responsible for the issuance of checks or custody of cash. The completed reconciliation should be reviewed promptly by an appropriate official. 9. Monitor cash receipts and disbursements by comparing recorded amounts to forecasted amounts and investigating variances from forecasted amounts.

Potential Misstatements - Cash Receipts Description of Misstatement

Recording receipts

Examples

cash Fraud:  Overstating cash receipts on the books by transferring cash between bank accounts without appropriate recording of the transfer to cover up an embezzlement of cash. Failure to record receipts from Fraud: cash sales  A cashier fails to ring up and record cash sales and embezzles the cash.

Internal Control weakness or Factors that Increase the Risk of the Misstatement

Fictitious

Error:  A bookkeeper accidentally omits the recording of the receipts from one cash register for the day.

Failure to record cash from Fraud: collection of accounts  A cashier embezzles receivable cash payments by customers on receivables; without

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Lack of segregation of duties of the functions of access to cash and record keeping; no effective review of bank reconciliations.

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Inadequate supervision of cashiers; failure to encourage customers to obtain cash receipts.

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Inadequate controls for reconciling cash register tapes and accounting records; inadequate controls for reconciling bank accounts.

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Lack of segregation of duties between personnel who have access to cash receipts

recording the receipts in the customers’ accounts.  

A bookkeeper accidentally who has access to cash receipts embezzles cash collected from customers and writes off the related receivables. 

Error: 

Early (late) recognition of cash receipts – “cutoff problems”

A bookkeeper accidentally fails to record payments on a receivable.

Fraud:  Holding the cash receipts journal open to record next year’s cash receipts as having occurred in this year.

Error:  Recording cash receipts based on bad information about date of receipt. Potential Misstatements – Cash Disbursements Description of Misstatements

Inaccurate recording of purchase or disbursement

a

Examples

Fraud:  A bookkeeper prepares a check to himself and records it as having been issued to a major supplier.

and those who make entries into the accounts receivable records. Lack of segregation of duties between personnel who have access to cash receipts and those who make entries into the accounts receivable records.

Inadequate reconciliations of subsidiary records of accounts receivable with the general ledger control account.

Ineffective board of directors, audit committee, or internal audit function; “tone at the top” not conductive to ethical conduct; undue pressure to show improved financial position.

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Failure to list and deposit cash receipts on a timely basis.

Internal Control Weakness or Factors that Increase the Risk of the Misstatement 

Inadequate segregation of duties or record keeping and preparing cash disbursements, or check signer does not

review and cancel supporting documents. Error: 

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Duplicate recording payment of purchases

and

Error: 

A disbursement is made to pay an invoice for goods that have been received. Disbursements for travel and entertainment are improperly included with merchandise purchases.

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Ineffective control for matching invoices with receiving documents before disbursements are authorized.

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Ineffective accounting coding procedures may result from incompetent accounting personnel, inadequate chart of accounts, or no controls over the posting process.

A purchase is recorded when an invoice is received from a vendor and recorded again when a duplicate invoice is sent by the vendor.

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Ineffective controls for review and cancellation of supporting documents by the check signer.

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Ineffective control over record keeping for and access to cash.

Unrecorded disbursements

Fraud:  In conjunction with recorded (but deposited) cash receipts, an employee writes and chases an unrecorded check for the identical amount. INTERNAL CONTROL OVER FINANCIAL INVESTMENTS

The most important group of financial investments consists of marketable stocks and bonds because they are found more frequently and usually are of greater peso value than the other kinds of investment holdings. Other types of investments often encountered include commercial paper issued by corporations, mortgages, and trust deeds, and the cash surrender value of life insurance policies. The internal auditors also must be concerned with derivatives that are used to hedge various financial and operational risks or for speculation. Derivatives are financial instruments that “derive” their value from other financial instruments, underlying assets, or indexes. The major elements of adequate internal control over financial investments include the following:

1. Formal investment policies that limit the nature of investments in securities and other financial instruments. 2. An investment committee of the board of directors that authorizes and reviews financial investment activities or compliance with investment policies. 3. Separation of duties between the executive authorizing purchases and sales of securities and derivative instruments, the custodian of the securities, and the person maintaining the records of investments. 4. Complete detailed records of all securities and derivative instruments owned and the related provisions and terms. 5. Registration of securities in the name of the company. 6. Periodic physical inspection of securities on hand by an internal auditor or an official having no responsibility for the authorization, custody, or record keeping of investments. 7. Determination of appropriate accounting for complex financial instruments by competent personnel. In many concerns, segregation of the functions of custody and record keeping is achieved by the use of an independent safekeeping agent, such as a stockholder, bank or trust company. Since the independent agent has no direct contact with the employee responsible from maintaining accounting records of the investments in securities, the possibilities of concealing fraud through falsification of the accounts are greatly reduced. If securities are not placed in the custody of an independent agent, they should be kept in a bank safe-deposit box under the joint control of two or more of the company’s officials. Joint control means that neither of the two custodians may have access to the securities except in the presence of the other. A list of securities in the box should be maintained in the box, and the deposit or withdrawal of securities should be recorded on this list along with the date and signatures of all persons present. The safe-deposit box rental should be in the name of the company, not in the name of an officer having custody of securities.

Potential Misstatements - Financial Investments Description of Misstatement

Examples

Misstatement of recorded value Error: of investments  Failure to record change in market values of investments. Fraud:

Internal Control Weakness or Factors that Increase the Risk of the Misstatement 

Inadequate accounting manual; incompetent accounting personnel.

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Unauthorized transactions

Incomplete investments

Misstatement of the value of closely held investment.

investment Fraud:  An employee with access to securities converts them for personal use. recording of Error:  Failure to record derivative agreements which are embedded in other agreements.

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Ineffective board of directors, audit committee, or internal audit function; not conducive to ethical conduct; undue pressure to meet earnings targets.

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Inadequate segregation of duties of record keeping for and custody of securities.

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a. inadequate accounting manual; incompetent accounting personnel. b. inadequate monitoring by internal auditors.

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INTERNAL CONTROL OVER RECEIVABLES Accounts receivable include not only claims against customers arising from the sales of goods or services, but also a variety of miscellaneous claims such as loans to officers or employees, loans to subsidiaries, claims against various other firms, claims for tax refunds and advantages to suppliers. Sources and Nature of Notes Receivable Notes receivable are written promises to pay certain amounts at future dates. Typically, notes receivable is used for handling transactions of substantial amount; these negotiable documents are widely used. In banks, and other financial institutions, notes receivable usually constitutes the single most important asset. Internal Control of Accounts Receivable and Revenue To understand internal control over accounts receivable and revenue, one must consider the various components, including the control environment, risk assessment, monitoring, the (accounting) information and communication system, and control activities.

Control Environment

Because of the risk of intentional misstatement of revenues, the control environment is very important to effective internal control over revenue and receivables. Management should establish a tone at the topof the organization that encourages integrity and ethical financial reporting. These ethical standards should be communicated and observed throughout the organization. Also, incentives for dishonest reporting, such as undue emphasis on meeting unrealistic sales or earnings targets, should be eliminated. Potential Misstatements – Revenue / Receivables Description of Misstatement

Examples

Recording unearned revenue

Fraud:  Recording fictitious sales without receiving a customer order or shipping the goods.  Intentional over shipment of goods.

Errors:  Recording sales based on the receipt of orders from customers rather than the shipment of goods.  Inaccurate billing and recording of sales.  Recording cash that represents a liability (e.g., receipt of a customer’s deposit) as revenue.

Early (late) recognition revenue – “cutoff error”

of Fraud:  Holding the sales journal open to record next year’s sales as having occurred in the current year.

Error:

Internal Control Weakness or Factors that Increase the Risk of the Misstatement 

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Ineffective board of directors, audit committee, or internal audit function; undue pressure to meet earnings targets. “top management action” not conductive to ethical conduct. Ineffective billing process in which billing is not tied to shipping information. Ineffective controls for testing invoices, or ineffective input validation checks and computer reconciliations to ensure the accuracy of databases. Inadequate accounting manuals; incompetent accounting personnel Ineffective board of directors, audit committee, or internal audit function; not conducive to ethical conduct; undue pressure to meet sales targets.

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Recording sales in the wrong period based on incorrect shipping information.

Recording revenue when Fraud: significant uncertainties exist  Recording sales when the customer is likely to return the goods.

Error: 

Recording sales when the customer’s payment is contingent upon the customer receiving financing or selling the goods to another party (e.g., consignment sales).

Recording revenue when Fraud: significant services still must be  Recording franchise performed by seller revenue when the franchises are sold even though an obligation to perform significant services still exists. Error: 

Overestimation of the amount of revenue earned

Amount of revenue earned on franchise is miscalculated

Fraud:  Misstating the percentage of completion of several projects by a construction company using the percentage of completion method revenue recognition.  Overestimating the

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Ineffective cutoff procedures in the shipping department.

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Ineffective board of directors, audit committee, or internal audit function; not conducive to ethical conduct; undue pressure to meet sales targets.

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Aggressive attitude of management toward financial reporting; incompetent chief accounting officer.

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Ineffective board of directors, audit committee, or internal audit function; not conducive to ethical conduct; undue pressure to meet sales targets.

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Aggressive attitude of management toward financial reporting; incompetent chief accounting officer.

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Ineffective board of directors, audit committee, or internal audit function; not conducive to ethical conduct; incompetent individuals involved in the estimation process. Aggressive attitude of

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percentage of completion on projects by a construction company using the percentage of completion method of revenue recognition.

management toward financial reporting; incompetent personnel involved in the estimation / accounting process.

Internal Control over Notes Receivable As previously stated, a basic characteristic of effective control consists of the subdivision of duties. As applied to notes receivables, this principle requires that: 1. The custodian of notes receivable not have access to cash or to general accounting records. 2. The acceptance and renewal of notes be authorized in writing by a responsible official who does not have custody of the notes. 3. The write-off defaulted notes be approved in writing by responsible officials and effective procedures adopted for subsequent follow-up of such defaulted notes.

INTERNAL CONTROL OVER INVENTORIES AND COST OF GOODS SOLD The importance of adequate internal control over inventories and cost of goods sold from the viewpoint of both management and the auditors can scarcely be overemphasized. In come companies, management stresses controls over cash and securities but pays little attention to control over inventories. Since many types of inventories are composed of items not particularly susceptible to theft, management may consider controls to be unnecessary in this area. Such thinking ignores that fact that controls for inventories affect nearly all the functions involved in producing and disposing of the company’s products.

Potential Misstatements – Inventory / Cost of Goods sold Description of Misstatement

Examples

Misstatement of inventory costs

Fraud:  Intentional misstatement of production costs assigned to inventory.  Intentional misstatement of inventory prices.

Internal Control Weakness or Factors that Increase the Risk of the Misstatement 

Ineffective board of directors, audit committee, or internal audit function; “tone to the top” not conducive to ethical conduct; undue pressure to meet

earnings targets. Errors:  The assignment of direct labor costs, direct material costs, or factory overhead to inventory items inaccurate.  Erroneous pricing of investory

Misstatement quantities

of

inventory Fraud:  Items are stolen with no journal entry reflecting the theft.  Inventory quantities in locations not visited by auditors are systematically overstated.

Early (late) recognition of purchases – “cutoff problems”.

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Ineffective cost accounting system; failure to update standard costs on a timely basis. Ineffective input validation controls on the database of inventory; ineffective supervision of the personnel that enter the costs on the final inventory schedule. Ineffective physical controls over inventories. Ineffective board of directors, audit committee, or internal audit function; “tone at the top” not conducive to ethical conduct; undue pressure to meet earnings targets.

Errors:  Miscounting of inventory by personnel involved in physical inventory.

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Ineffective controls or supervision of physical inventory.

Fraud:  Intentional recording of purchases in the subsequent period.

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Errors:  Recording purchases of the current period in the subsequent period.

Ineffective board of directors, audit committee, or internal audit function; “tone at the top” not conducive to ethical conduct; undue pressure to meet earnings targets.

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Ineffective accounting procedures that do not tie recorded purchases

to receiving data.

INTERNAL CONTROL OVER PROPERTY, PLANT AND EQUIPMENT The term property, plant and equipment includes all tangible assets with a service life of more than one year that are used in the operation of the business and are not acquired for the purpose of resale. Three major subgroups of such assets are generally recogni...