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Running head: Report on Internal Control

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Milestone 3: Report on Internal Control Haley C Aguirre Southern New Hampshire University

REPORT ON INTERNAL CONTROL Internal Control Willis and Adams will evaluate the five components of Earth Wear’s internal control for any gaps that might lead to deficiencies or material misstatements and will give recommendations for how these gaps can be improved, and how the misstatements can be avoided. We will use the Committee of Sponsoring Organizations (COSO) internal control framework in our evaluation, as this is the framework that the majority of firms in the United States have adopted. The purpose of the COSO framework is to help firms establish, assess, and enhance their internal controls. Evaluating Earth Wear’s internal controls is vital to our audit because the “existence or absence of internal controls in operations and financial reporting determines the output quality of the financial statements” (COSO Framework). In addition, when a firm has internal controls that are present and functioning, it yields reasonable assurance to likely users of financial statements, that the amounts are accurate and can be relied upon for decision making. A. Control Environment A firm’s control environment is comprised of the set of standards, processes, and structures that are the basis for carrying out internal controls across the organization. In line with the COSO framework, the board of directors and senior management set the tone at the top, and this has a pervasive impact on the firm’s overall internal control system. Earth Wear has taken this aspect seriously and their management has created an environment where internal controls are taken seriously. Earth Wear’s management is very concerned with misstatements due to error or fraud and takes actions to mitigate the risk of misstatements. One of these actions is the management report on internal controls over financial reporting, which is issued periodically and includes a statement on the effectiveness of Earth Wear’s internal controls. The issuance of this

REPORT ON INTERNAL CONTROL report indicates to the public that Earth Wear tests their own controls periodically and is aware of any deficiencies. In Willis and Adams history of working with Earth Wear and being their independent auditor, we have found the management report to be mostly accurate. Earth Wear’s management has always been responsive to any recommendations Willis and Adams have provided on their internal controls. Earth Wear’s board of directors is composed of five senior management members and four independent board members. They meet quarterly to review performance, and they also meet when an event or transaction occurs that significantly affects the company. Minutes of the board of directors’ meetings are kept and prepared by the corporate secretary within one week, and the secretary signs each record after the board approves them. Earth Wear has an independent audit committee that is made up of two directors of the company who are not members of the management team. They meet each quarter, and minutes of every meeting are kept. The audit committee also meets with both internal and external auditors each quarter. Earth Wear uses conservative accounting policies and are thorough in developing accounting estimates. If any accounting issues arise, management will consult with Willis and Adams, and management is willing to make adjustments or book any misstatements identified during the course of the audit. The firm’s organizational structure is well developed and there are clear lines of authority present among functions of employees. The human resources department has “sound policies for hiring, training, evaluating, counseling, promoting, compensating, and taking remedial actions” against employees as seen fit. Upper management is able to communicate to employees their duties and control responsibilities during their initial training. Overall, Earth Wear’s accounting personnel are well trained and have the competence and experience needed to carry out their duties effectively. During the year ending December 31, 2016, Earth Wear had their controller, Brad Norton, leave for another apparel firm unexpectedly

REPORT ON INTERNAL CONTROL in February. The new controller, Carol McKay, wasn’t appointed until November and received a promotion from her former title of VP of external reporting. The time between the former controller leaving and the new one being hired was longer than preferred, and Earth Wear needs to design and implement a succession plan for the executive positions to be prepared for unexpected instances. The lack of a succession plan is a design deficiency because appointing Carol McKay was a risk due to executives and Willis and Adams audit team having reasonable doubts about her qualifications. This is a significant deficiency in design due to the nature of the controller’s position and duties, which are a vital part of financial statement preparation. Willis and Adams highly recommends that Earth Wear design and implement po B. Risk Assessment A firm’s risk assessment process forms the basis for how each risk is managed. Management has responsibilities to adhere to this, which include: the responsibility to specify objectives for categories relating to operations, reporting, and compliance that are clear enough to have the ability to identify and analyze risks, management must also consider the suitability of their objectives, and management has the responsibility to consider the impact of possible changes in the external environment that could render internal controls ineffective. Earth Wear Clothiers current risk assessment policies are well designed, and they maintain clear objectives in “terms of profit, budget, and financial and operating goals” (EW Corporate Governance Memo). Each objective is written and actively communicated and monitored. Earth Wear maintains a budgeting process that has built in monitoring. The risk management department is heavily relied on to identify risks that could affect the firm and they recommend appropriate actions. The risk management committee is responsible for considering how future events, such as internet sales, could affect the firm. Earth

REPORT ON INTERNAL CONTROL Wear’s management holds monthly meetings to talk about recent events. They are aware of their current risks which are finding an alternate sourcing for products and facing an increase in competition. Willis and Adams found no issues on internal controls related to risk assessment. A. Information Systems The COSO framework states that a firm must have both internal and external communication. Internal communication allows personnel to receive clear messages from senior management that their control responsibilities are to be taken seriously. External communication allows for the inbound communication of relevant external information, and also provides information to external parties in response to requirements and expectations. Earth Wear has established procedures which prevent unauthorized “access to, or destruction of, documents, records, assets, programs, and data files” (Connect HW module 7). Their IT department maintains controls over access to computer operations and data programs and files. Earth Wear uses both standard and automated information systems in which the automated systems provides management reports on the firm’s performance “relative to established objectives, including relevant external and internal information” (Willis and Adams 2015 entity info). Earth Wear revises their information systems over financial reporting annually, and the development is based on their strategic plan. In total, there are good communication channels across departments due to adequate flow of communication through the firm, which enables employees to discharge their responsibilities. In the case of policy violations, there is a policy and procedure to follow, where any suspected violation is reported to the appropriate VP, and any reports are anonymous. Earth Wear recently switched to a new information system in 2015, which is now working well and has helped in

REPORT ON INTERNAL CONTROL achieving their business objective of satisfying customers. Although the new system is properly designed and implemented, the transition period was expensive and was laden with issues. B. Control Activities Actions established in a firm’s policies and procedures that ensure management directives to mitigate risks in achieving their objectives are a firm’s control activities. These control activities are to be “performed at every entity level, are preventive and detective in nature, and can be both manual and automated. When a firm selects and develops their control activities, the segregation of duties should be built into this process” (COSO pdf). Earth Wear puts a good faith effort in maintaining good controls and implements the COSO principle of tone at the top. Regardless of Earth Wear’s effort to maintain controls, Willis and Adams found deficiencies during the audit, and these are explained in better detail in the table at the end of this section. In particular, two material misstatements were detected that Willis and Adams judged to be deficiencies in internal control design. The first deals with intercompany transactions, which occur each month and there are many of them. These transactions are in relation to “transfers of inventory between warehouses and business units.” These are a deficiency because these transactions are frequently material. Earth Wear has a policy to handle these transactions, but have no process implemented to carry out the policy. While no misstatements were detected, this is a material issue because the lack of a procedure heightens the risk of inventory being misstated. Willis and Adams has recommended that Earth Wear design and implement a procedure to reconcile intercompany accounts. These reconciliations should be done monthly, and employees should double check theses transactions as the occur using documentation and matching the transaction documentation at both shipping and receiving locations and ensure the invoices match to the ledgers. The second design deficiency is in the “lack of cutoff procedures

REPORT ON INTERNAL CONTROL to ensure timely recording of period end accruals.” This misstatement exceeded tolerable misstatement for the account, and we have recommended a procedure to fix this. Another deficiency found deals with the improper recording of transactions in subsidiary ledgers. These misstatements did not meet the tolerable misstatement threshold but should be paid more attention to regardless. These misstatements are happening because of the controller’s lack of experience and knowledge. This is an operation deficiency and our recommendation is that Earth Wear train their controller to improve these issues. There is also an additional design deficiency in their recording of accounts receivable in subsidiary ledgers. This is a design deficiency because Earth Wear has a policy to mitigate this issue, but there is no follow through being implemented. This deficiency required an audit adjustment and is significant because if accounts receivable are over or understated, it will affect their total liabilities. There should be reconciliation of the subsidiary ledgers, performed by the appropriate level of management to ensure accurate statements. EARTHWEAR CLOTHIERS

Account Name

2016 Unaudited Balance

Total Balance Sheet Assets/Liabili ties

$389,428

Receivables, net

Inventory

Deficiencies & Material Misstatements December 31, 2016 (In thousands) Adj % Adj. % % of Tolerab of Requir of Planning le Accoun ed Acc Materiality Misstat t ount ement Balanc Bala e nce $1,947 76.7% 0.5% None none

$8,643

$1,269

50%

15%

$376

4%

$147,693

$1,904

75%

1.6%

none

None

Discovery & Determination

G/L transactions not properly recorded in subsidiary ledgers: Significant control deficiency - frequency of transactions. AR subsidiary ledgers not reconciled timely & accurately: Significant control deficiency under tolerability, but adjustment required Frequent material inventory transfers with

REPORT ON INTERNAL CONTROL

Accrued liabilities & Profit sharing

$33,600

$1,904

75%

5.8%

$3,578

10.6%

lacking reconciliation: Material control misstatement – frequency and size. Cut-off procedures & recording found lacking in accruals. Material control misstatement – exceeds planning materiality, adjustment required.

C. Monitoring Activities Currently, Earth Wear maintains effective monitoring activities, and takes into consideration any customer recommendations, which are implemented if the management and the board find them to be cost beneficial. Their internal audit function is an active department and the audit committee regularly meets with both internal and external auditors to discuss any control. There are a low number of customer complaints, about 1 of out every 5,000 customer invoices contains a complaint. Most of these are relating to delays in receiving goods on order by Earth Wear to due to minor billing discrepancies. All complaints are immediately investigated to discern any underlying causes, which are corrected in a timely manner, when any internal control deficiencies are found. The Board of directors keeps their focus on the control environment and the relating monitoring activities, and any recommendations received are implemented if they are cost beneficial. Willis and Adams found no deficiencies in Earth Wear’s current monitoring activities.

REPORT ON INTERNAL CONTROL

References Internal Control – Integrated Framework: Executive Summary (2013). Committee of Sponsoring Organizations of the Treadway Commission. Retrieved from https://www.coso.org/Documents/990025P-Executive-Summary-final-may20.pdf Messier, W. F., Jr., Glover, S. M., & Prawitt, D. F. (2017). Auditing & assurance services: A systematic approach (10th ed.). New York, NY: McGraw-Hill Education. Willis & Adams, CPAs: Audit Manual Excerpt: Materiality Guidelines. (2016) EarthWear Hands-on Mini cases. New York, NY: McGraw-Hill Education. Willis & Adams, CPAs: Background of EarthWear. (2016) EarthWear Hands-on Minicapes. New York, NY: McGraw-Hill Education. Willis & Adams, CPAs: Profile (2016). Retrieved from http://lectures.mhhe.com///willisadams/Profile.htm.

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