ABC Internal Controls PDF

ABC Retailers — Internal Controls
Required:
1. What are the key considerations when evaluating the severity of a deficiency in a control that
directly addresses a risk of material misstatement?
When evaluating the severity of a deficiency as it relates to the risk of material misstatement it
is important to consider whether there is a possibility that a fraud or a misstatement occurs and
is not detected by the internal controls in place. Also, the magnitude or materiality of the
misstatement should be considered. This includes the possibility on any type of fraud and any
material misstatements. Material misstatements are considered to be any large amounts
compared to total amount for a given account or the volume of transaction in the accounts, as
well as the riskiness of the accounts affected as well. Any mitigating controls that are or put in
place should work to detect and prevent fraud and any material misstatements. Some types of
common controls to consider are oversight by the audit committee, create a whistleblower
program and establish controls for journal entries or other types of manual entries or changes.
Also, any internal control system needs a separation of duties as well as an understanding of
the process and everyone’s duty in order to comply with the internal controls. In order to
evaluate the severity of the deficiency the amount or possibility of undetected fraud and/or
material misstatements must be able to satisfy or be in accordance with that of a prudent
official; if not then the internal controls must be strengthened to address any material
weaknesses.
2. Does the Assistant Controller’s failure to adequately review the Vendor Change Form
represent a deficiency in the design or operating effectiveness of the control?
It represents a deficiency in the design and operating effectiveness of the control. An example
of a deficiency in the design of the controls established to approve vendor changes forms is that
the Assistant Controller should not be allowed to review and approve the vendor bank change.
This would fall under the fact that it is not a good separation of duties. The fact that he can
review and approve the documents, for one, means that he is approving his review. There could
be mistakes in the document that he might have missed. Another thing could be the fact that
when reviewing, he might change some information and then approve that change. In addition,
the same form is used to add new vendors and make changes to existing vendors so this can
bring confusion on which procedures to follow to confirm vendor’s information. The control
also fails to operate effectively, the case mentioned that the internal auditor evaluated all 105
vendor change form reviewed by Assistant Controller and only 5 of those vendors had the
information required by the policy.
3. Is the failure in the vendor request change form control indicative of a material weakness in
internal control over financial reporting?
Although the failure in the vendor request change form control amounted to a loss of $2
million, below the $8 million materiality threshold, it is a material weakness in internal control
over financial reporting due to the fact that it was related to fraudulent activity. The failure to
adhere to the proper procedures when granting a request for a vendor bank account change
led to the discovery of one fraudulent account. However, there were approximately 105 vendor
requested bank account changes performed throughout the year in which only 5 were
performed using the appropriate procedures. Therefore, the possibility of more fraudulent
instances is likely and of concern.
4. Would the deficiency warrant disclosure in the Company’s Form 10-K, Item 9A? If so, what
information would the Company be expected to disclose?
Due to the nature and the possibility of not only the detected fraud of $2,000,000, but of
additional fraud or material misstatements on the other 105 vendors who made bank
statement changes in the same fiscal year with the current level of internal controls not being
sufficient, ABC should disclose in their 10-K Item 9A that their financial statements for that year
should not be relied upon and that the financial statements affected will be restated. ABC will
also need to state that there was a control deficiency in their internal controls, which is a
material weakness, and that those controls were not effective.
5. What implications does the deficiency have on other direct or indirect controls?
The following are identified risks of cash disbursements: That a false or incorrect vendor turns
in an invoice without providing a good or service, invoice is received, but goods or services are
not, and that payments are not authorized or correct. As long as the internal controls in place
are deficient, auditors will need to evaluate all of these areas carefully, as they may also include
fraud and/or material misstatements. This would include additional testing of related controls
such as bank statement reconciliations, manual checks having proper documentation and
management approval, management reviews and authorizes all related entries and any
variances are analyzed and explained. Also, as one of the deficiencies was an employee not
understanding the correct procedure, this brings to the question what other procedures were
not used correctly. This makes almost every procedure questionable as they will have to review
every procedure with the employees, which may have an effect on not just direct, but also
indirect controls for the company.

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ABC Retailers — Internal Controls

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