You are the senior auditor of Richardson’s, and you are auditing the sales and receivables area of Clarkson Ltd, a water filter manufacturer, for the year ending 30 December 2016. The following procedures have been identified.

All sales are made on credit, with outstanding accounts due and payable within 30 days. Customers can purchase the water filters from Clarkson by emailing or telephoning through their purchase order. Immediately on receipt of a customer’s request, a sales clerk prepares a sales order.

Sales orders are manually pre-numbered and produced in triplicate. One copy of the sales order is sent to the shipping department, one to the invoicing department and one copy is filed in the sales department.

On receipt of the sales order by the shipping department, the shipping clerk obtains the items from the warehouse, packages them, prepares a shipping note and arranges transport.

Shipping notes are also manually pre-numbered and produced in duplicate. The original shipping note is sent to the invoicing department, and the second copy is filed by the shipping clerk.

The shipping clerk transfers the information from the shipping note to a delivery docket, which is pre-numbered and produced in triplicate. Two copies of the delivery docket are given to the carrier. One of these is retained by the customer, while the other is signed by the customer and retained by the carrier. The shipping clerk forwards the third copy of the delivery docket to the invoicing department.

A clerk in the invoicing department checks that the information on the purchase order, the shipping note and the delivery docket match each other and then prepares the sales invoice. Sales invoices are pre-numbered and produced in triplicate. One copy of the sales invoice is sent to the customer, one is forwarded to the accounting department, and the third is filed by the invoicing clerk.

The accounts clerk uses the invoice to make an entry to the sales journal, which is used to update the sales ledger and the accounts receivable subsidiary ledgers. The sales invoice is then filed by customer name.

All payments are made by cheque and mailed to Clarkson along with the remittance advice. Two staff are assigned to receive these payments – one who opens the mail and records the receipt of the payment on a cheque list. The other staff member takes custody of the cheques and matches them to the remittance advice, then forwards them to the accounts receivable clerk.

The accounts receivable clerk updates the subsidiary ledger.

Bank reconciliations are performed monthly by an accounting clerk, who is not responsible for receiving payments.

Sales returns and allowances only are processed after the financial controller has authorised them.

Sales returns and allowances only are processed after the financial controller has authorised them.

Bad debts are written-off only on the authorisation of the financial controller, after discussion with the credit manager.

Required

(a) Identify three (3) internal control activities in Clarkson’s sales and receivables, and explain if the control activity prevents or detects material misstatements, and how this is achieved.

(b) For each of the controls identified in (a) provide one (1) test of control that could be undertaken to verify the effectiveness of the control. Justify your answer

(c) Identify and explain three (3) internal control weaknesses in Clarkson’s sales and receivables processing system.

 

d) For each of the weaknesses in (b) identify one account balance at risk of misstatement and the assertion at risk. Justify your answer.

 

(e) Select two (2) of the weaknesses identify in (c) and explain one improvement to controls that could be implemented for each, to reduce the risk of material misstatements.

 

Answers:

Executive Summary

In the given assignment, a report needs to be prepared as an auditor of the Richardson’s who is conducting an audit of the sales and the receivables area of the client named Clarkson Ltd. A series of activities and the procedures being followed by the company has been identified starting from placing an order by customers to delivery and collection from the debtors. The internal control beingmaintained at the entity needs to be identified, both on the positive as well as on the negative side, which is contributing to the effectiveness of the control and ones which is posiung a risk of material misstatement in few of the accounts. Recommendations and conclusion have also been drawn based on the above inputs.

Internal control Activities in Clarkson

Internal control is a group of activities which if properly implemented within the organization can lead to strong control and lowers the risk of material misstatement within the organization. In case the internal control is strong within the organization, the auditor would have to apply less of substantive and compliance audit procedures while doing auditing and vice versa in case it is weak. Furthermore, the implementation of strong internal control practices are needed as per the SOX guidelines and increasingly lowers the risk of frauds within the organization. The given company Clarkson has a lot of internal control activities being implemented and practiced within the organization. Few of them are:

• The company is practicing segregation of duties is some of the areas like the sales cleark prepares the sales order, the invoicing clerk prepares the invoice and the accounts clerk passes a journal entry in the books of accounts. Two other staffs are there, one for receiving the cheques by mails and recording the receipt and the other for taking custody of cheques. All this ensures that no single person in the system can take control of the entire group of activities and override the set procedures(Bizfluent, 2017). Since, it is being handled by many persons in chain, it can easily help in identifying the material misstatement.
• The other critical control being placed by Clarksons is preparation and filing of the Sales order in triplicate, one of which is sent to the shipping department, one to the invoicing and one being held back at the sales department. This ensures no body in the loop misplaces the order copy and there is proper documentation of all the orders received and no order can be intentionally misplaced till final delivery is done.
• The 3^rd control being placed is the bank reconciliations being prepared by the accounting clerk on a monthly frequency which will help in identifying material misstatements, if any, and where the gaps are. It further should be done by the independent person for the process to be risk free. Currently, he is also responsible for making the sales journal and updating the accounts receivable subsidiary ledger. This can lead to fraud in some cases, therefore, different people can be hired for the same.

Test of control for measuring effectiveness of control

The above stated control activities can be checked for its effectiveness by using the below test of controls:

• The segregation of duties can be checked by checking the signature of the respective clerks and officials on the sales order copies, the delivery challans, the warehouse receipts, the shipping note, the delivery docket and the sales invoice. All of them should have the sign of the dedicated personnel assigned with the job, it should be properly dated and most importantly since all of them are pre numbered, it should be in a sequence and in case the same is not available, the test of control fails.
• Since the sales order is prepared in triplicate, the same should be properly filed with all the requisite supporings in 3 different departments namely the invoicing department, the sales department and the shipping department. It should match in every single aspect and in case, even one of the copies is missing or there is a same person at more than 1 place, the test of control fails(Chron, 2017).
• The 3^rd control being an accounting control w.r.t. bank reconciliation, it should be matching at every month end with reasons being established for whatever differences are being established. In case the same is not matching, then it is matter of concern and the risk of material misstatement rises. The reconciliation in a more short interval like fortnightly will ensure further effectiveness of the control.

Internal control weaknesses

There are a lot of areas which still needs improvement for strong internal control to be implemented some of which are:

• The orders from customers is received over emails and telephones without a proper documentation. This may lead to misplacing of the orders and a situation where someone has either fraudulently not recorded the order or has missed o(DeZoort & Harrison, 2016)ut on recording the same as a sales order. This needs to be properly documented and have a better tracking system.
• Other control weakness is the entire responsibility of taking decision on write off of the debtors being given to the financial controller. Even though the credit manager is involved in the same, but this can lead to forming groups and negotiation among the team and writing off huge amounts as bad debts and hence the same should have involvement of the top management to give the final decision and approval on bad debts as well as sales allowance as both impacts the profits by great deal.
• In the entire list of activities, the internal audit function hasn’t been discussed, the same should be implemented within the organization to check whether the proper documentation is there in place or not, whether all the supportings are in place and window dressing is not being done. Also, monitoring procedure in terms of credit days and outstanding debtors, collection and sales analysis is missing which is very much required in order to retaliate a growing function within organization.

Account balance and assertion at risk

From the above identified weaknesses in the internal control system, below are the risks being posed:

• The order being received over mails and calls will directly impact the sales account and the cash collection from the debtors. It will also lead to loss of inventory and improper bank reconciliations if properly not recorded. This impacts management assertion that all the sales have been completely accounted for.
• The authority for writing off debts and approving sales allowances directly impacts the net margin by impacting the expenses GLs. If either of them is approved in case of inappropriate sales, the same can lead to negative cash flows and losses. This impacts the assertion that bad debts have been allowed after due course of action and efforts to collect the same, legal action has been initiated and it is almost certain that the amount is not collectible.
• The absence of internal audit and financial management function directly impacts overall financial statements, the revenue and collectability from debtors. It impacts the assertion that the company is trying to bring debtors outstanding days in control and working to increase the overall sales and revenue(Jones, 2017).

Conclusion and Recommendation for implementation of control

In view of the above mentioned irregularities, there are many areas which can be improved to reduce the risk of material misstatements:

• A proper online system of recording the purchase order by the customers can be put in place such that nothing goes out of track and everything can be maintained electronically at customer as well as order level. This will not only ensure proper recording of orders but 360 degree analysis.
• Management can reserve some decisions and a proposal note should be there in place from the financial controller for any major financial decision like bad debt writing off or changes in sales allowance policy which should be approved and signed by the top management before implementation.

References

Bizfluent, 2017. Advantages & Disadvantages of Internal Control. [Online]
Available at: https://bizfluent.com/info-8064250-advantages-disadvantages-internal-control.html.

Chron, 2017. five-common-features-internal-control-system-business. [Online]
Available at: https://smallbusiness.chron.com/five-common-features-internal-control-system-business-430.html.

DeZoort, F. & Harrison, P., 2016. Understanding Auditors sense of Responsibility for detecting fraud within organization. Journal of Business Ethics, pp. 1-18.

Jones, P., 2017. Statistical Sampling and Risk Analysis in Auditing. NY: Routledge.