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Control and Control Risk

Controls pertaining to recording inventory transactions are important to assessing control risk for the existence and occurrence, completeness, valuation or allocation, and presentation and disclosure assertions for manufacturing transactions and inventories.

1. How does the auditor perform a walk through of production transactions? What documents will the auditor collect? Regarding controls, what will the auditor look for?

Documentation of the authorizations of production is provided by issuing pre-numbered production orders. In addition, a material requirements report should be prepared to show materials and parts needed and on hand
management should have controls in place to ensure that purchased raw materials quantities are appropriate for production levels. Production performance evaluation reports should be prepared to evaluate production quantities, product quality, and delivery schedules.

2. What control could be used to prevent or detect false work orders or fraudulent requisitions?

Management should limit physical access to inventories and fixed assets. In addition, access to information about inventories and fixed assets should be restricted by using access controls and compatibility tests. All internal movements of inventory through the production process should be documented by using (1) materials requisitions to authorize the release of raw materials to production, and (2) move tickets to document the movement of inventory.

In addition, the receiving department should not accept returned goods without an authorization number. Customers should be required to obtain authorization by the company in advance.

3. What control could be used to prevent or identify the taking of company inventory by the spare parts custodian?

If management fails to institute effective controls, this condition could lead to theft, pilferage, embezzlement, and corruption. When employees have knowledge of where the weaknesses are in internal controls, such as approvals of transactions and access controls over automated records, they have the opportunity to commit fraud.

As an example, employees can bill the company for services from a nonexistent company if the accounts payable staff does not review services for completion or materials for receipt.

4. Describe a control that would prevent or identify "shell company" schemes.

Economic motive is a need for money to pay for college tuition, hospital bills, drugs, or alimony and child support. Sometimes honest people can fall into circumstances where there is an unexpected need and there appears to be no other way to solve the problem.

In addition, the inability to obtain a better lifestyle through legitimate means can lead to the motivation to commit financial crimes by persons in trusted positions.

Some companies have "ethics officers" to assist those employees who experience financial and other pressures.

5. What is a control that could prevent or identify fraudulent refunds of merchandise by employees?

The need for controls within the work environment is very critical in the operation success of the organization. One must think of every possible situation to prevent too much authority being placed under one position. Using checks and balances, a company can determine if a new control is needed or if there is a gap within the internal control process.

6. Do you think storage of source documents becomes an important factor when determining controls within an organization?

Solution Preview

1. One of the main tools that an auditor relies on for a walk through of any area, including production, is observation. The auditor takes note of how production is run, what the employees are doing, where products are starting from, being moved through to, and where they are finished. A basic understanding of the production process is absolutely crucial to the auditor in examining the production process. By completing a walk through in this manner, the auditor is in compliance with Auditing Standard No. 5, An Audit of Internal Control Over Financial Reporting That Is Integrated with An Audit of Financial Statements. The PCAOB actually tells auditors to complete the walk through by starting at the beginning, where the material first comes out of inventory, and to follow that item, including the computer and other IT checks the products go through, to the point where that item goes onto the financial statements. During the walk through, the auditor should also question personnel as to the workings of the process, which allows the auditor to combine that knowledge with the auditor's knowledge of internal control procedures in use, which helps to verify if the production process has an effective level of control, given the process itself. The reports stated above are the documents collected. In addition, the auditor would collect any document that shows the production flow through the production process. This also includes documents showing damaged and defective materials from the production process to ensure they're being ...

Solution Summary

This solution gives thorough explanations to the auditing questions presented for discussion, including production transactions, controls, false work order detection, fraudulent requisitions, theft of inventory by the spare parts custodian, and controls that prevent shell companies. I also answer questions regarding fraudulent merchandise refunds and the storage of source documents. All questions presented by the student are thoroughly answered.