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Controls, segregation of duties, inventory overstatement

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1. How does the accounting write-off of design and development costs as current expenses affect managers' incentives to incur these costs?

2. Explain the importance of separation of duties to a system of internal controls.

3. Explain inventory overstatement. A merchandising company has asked you to advise it on how to detect fraudulent financial reporting. Management wants your help in detecting inventory overstatement. Further, management wants to know how to find evidence of inventory overstatement.

a. Using your own numbers, make up an example to show management the effect of overstating inventory. Show how inventory overstatement at the end of Year 1 carries through to the beginning inventory overstatement in Year 2.

b. Prepare a brief report to management suggesting ways management could detect inventory overstatement.

4. Three students share a house. Having better things to do than clean house, they hire someone to come in and clean once each week. How should they share the costs of the housekeeper? One simple solution is to share the cost equally. Suppose, however, that one student's bedroom is twice as large as each of the other students' bedrooms. The second student has a small bedroom and uses the house only four days per week. The third student uses the house all week, has a small bedroom, and is generally acknowledged to be the cleanest of the three. Sharing the cost equally is simple, but is it fair?

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Solution Summary

Your discussion is 835 words includes 12 forms of evidence of inventory overstatement and 10 ideas for detecting inventory overstatements. Segregation of duty is explained as well as practical impact of expensing research and development.

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1. How does the accounting write-off of design and development costs as current expenses affect managers' incentives to incur these costs?

Given that they are immediately expensed, there is a tendency to cut them back during periods when earnings are under pressure (lower than goal). Analysts, fortunately, often add them back during earnings forecasts knowing that they may have a longer impact than the current period, so that helps to soften the profit hit. Given that they are not given credit for "investing" when they incur research and development costs, it does put a damper on how much any one period can sustain. R&D is therefore often planned so that it is a certain level each period and does not make any one period unprofitable by a large outlay.

2. Explain the importance of separation of duties to a system of internal controls.

Separation of duties is a way to separate access to assets from access to accounting records so that it is hard to take off with assets without detecting the loss. Duties that permit access to assets, typically cash or inventory, are "incompatible" with duties to record those assets in the records. That way one person could not take off with assets and change the records (or fail to record it) to cover up the theft. Separation of duties also helps to find unintentional errors. By separating the reconciliations from those involved in the transactions in the reconciled report, a second set of eyes to check to see what everything that should be on the report made it and nothing extra that should not be there. For example, the person reconciling the bank statement should have no access to cash collections or payments but is checking ...

Solution provided by:
Carol Sargent, PhD
Education
  • BSc, University of Virginia
  • MSc, University of Virginia
  • PhD, Georgia State University
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