AUDITING LABORATORY

SECTION 5 CASE 5.3

Arranged by:

Syafira Azzahra 165020307141011

INTERNATIONAL UNDERGRADUATE PROGRAM IN ACCOUNTING
FACULTY OF ECONOMICS AND BUSINESS
BRAWIJAYA UNIVERSITY
MALANG
2019
Red Bluff Inn & Cafe
Establishing Effective Internal Control in a Small
Business

BACKGROUND
An entrepreneur by the name of Francisco Fernandez recently entered into a new
venture involving ownership and operation of a small, 26-room motel and café. The
motel is located in a remote area of southern Utah. The area is popular for tourists,
who come to hike and mountain bike through the area’s unique red rock terrain.
Francisco has hired you to provide advice.
Francisco hired a young couple to run the motel and café on a day-to-day basis
and plans to pay them a monthly salary. They will live for free in a small apartment
behind the motel office. The couple will also be responsible for hiring and supervising
the four or five part-time personnel who will help with cleaning the rooms, cooking,
and waiting on customers in the café, etc. The couple will maintain records of rooms
rented, meals served, and payments received (whether by cash, check, or credit card).
They will make weekly deposits of the business’s proceeds at the local bank.
As the time approaches for the business to open, Francisco is concerned that he
will have little control over the operations or records relating to the motel and café,
given that the day-to-day control is fully in the hands of the couple. He lives almost
five hours away, in northern Utah, and will only be able to visit periodically. The
distance is beginning to make Francisco a bit nervous. He trusts the couple he has
hired, but has been around long enough to know that it is unwise to place employees
in situations where they might be tempted.
Francisco needs your help to identify possible ways his motel and café could be
defrauded. He especially wants your assistance to devise creative internal controls to
help prevent or detect fraud.

REQUIREMENT 1
What are your two biggest concerns relating to possible fraud for the café part of the
business? For each concern, generate two or three controls that could effectively
reduce risk related to your concerns.

● The couple could steal some of the revenue brought in from the sale of food in
the café.

● The couple could allow friends/family to eat in the café without charge or at an
unapproved discount.
● The couple might keep false records that do not accurately show the performance
of the café

● The couple might record personal expenses as expenses of the café.

● The couple could use food items from the restaurant for their own personal use.

● The couple could purchase and serve cheaper, poor quality food and make
records appear as if they had purchased more expensive, higher quality food

Control Required:

● Require a receipt to be given to all customers. Place a sign in the café notifying
customers that if they do not receive a receipt, they can call Fransisco’s telephone
number for a free meal and a $10 gift certificate.

● Establish a set of policies and procedures that require good record keeping and
that clearly specify appropriate uses of café resources.

● Require all food and supplies received from suppliers to be recorded. A periodic
inventory can be performed and compared against purchases and estimated usage
based on records of meals served to identify miss-allocation of inventory.

● Periodically reconcile waiters’/waitresses’ records of meals served with the chef’s

records of meals cooked and with register receipts.

● Require all checks (including payroll) over $500 to be signed by Fransisco.

● Require a bank account ledger to be kept on all deposits and checks. Fransisco
can use this information along with the monthly bank statement to perform the
monthly bank account reconciliation.

● During his periodic visits to the café, Fransisco can review records and other
evidence of the café’s expenses to verify everything was used for legitimate
business purposes.
● Do not allow the cashier to be the same person responsible for recording daily
cash receipts.

● Require all checks, when received, to be immediately stamped with information

instructing the check be deposited only in the café’s account.

● Contract separately with a food supplier to deliver food to the restaurant, and
have the food supplier send copies of invoices and listings of food supplied
directly to Fransisco.

● Hire an assurance provider to perform periodic, unannounced “independent

checks.”

REQUIREMENT 2
What are your two biggest concerns relating to possible fraud for the motel part of the
business? For each concern, generate two or three controls that could effectively
reduce risk related to your concerns.

● The couple could steal some of the revenue collected from the rental of motel
rooms.
● The couple could allow friends/family to stay in the motel without charge or at an
unapproved discount.
● The couple might keep false records that do not accurately show the performance
of the motel.
● The couple might record personal expenses as expenses of the motel.

Control Required:

● Require the couple and the cleaning staff to keep separate records of the motel’s
occupancy and periodically check to make sure these records match. The cleaning
staff could directly mail a copy of the cleaning reports to Fransisco on a weekly
basis. The couple’s occupancy records should match with the cleaning staff’s
records of rooms cleaned.
● Establish a set of policies and procedures that require good record keeping and
that clearly specify appropriate uses of motel resources.

● Require all checks (including payroll) over $500 to be signed by Fransisco.

● Require a bank account ledger to be kept on all deposits and checks. Fransisco
could use this information along with the monthly bank statement, which could
be sent directly to him from the bank, to perform the monthly bank account
reconciliation. An imprest bank account could also be used.

● During his periodic visits to the motel, Fransisco can review the records and other
evidence of the motel’s expenses to verify everything was used for legitimate
business purposes.

● Require receipts to be given to all customers and that a copy of all receipts be
kept at the motel.

● Require all checks, when received, to be immediately stamped with information

instructing that the check be deposited only in the motel’s account.

● Install a security camera that continuously records a view of the customer and
register areas.

● Hire an assurance provider to perform periodic, unannounced “independent

checks.”

REQUIREMENT 3
Describe the potential impact of your proposed controls on the morale of the couple in
charge of the day-to-day operations. How might Francisco deal with these concerns?

Another cost to consider with each potential control is the effect it could have on
employee morale. While it is necessary to minimize opportunity and temptation, it is
also important to not portray a complete lack of trust in the employees. Constant,
intrusive monitoring or surveillance could damage morale and result in detrimental
effects. The benefit of each control must be carefully weighed against the possible
negative effect it could have on employee morale. Fransisco might be able to best deal
with the morale issue by explaining to the couple the importance of implementing the
controls. He should demonstrate to them that the controls are not a showing of his
lack of trust in them, but rather, they are designed to help the business run as
efficiently as possible no matter who is running the business today or 20 years from
now. Additionally, he could point out to the couple that the controls protect them from
being inappropriately accused of wrong doing by all other parties involved with the
business. Given the nature of a small business environment, and the fact that no set of
internal controls can be absolutely effective, Fransisco will have to show a reasonable
level of trust in the couple and their management of the motel and café. Consider, for
example, that if employees were to collude, many of the controls suggested above
would be ineffective. Thus, as in larger businesses, hiring quality employees with
integrity is of critical importance.

REQUIREMENT 4
Briefly describe the impact each proposed control would have on the efficiency of
running the business. Are the controls you generated both effective and efficient?

While the students will come up with many suggested controls, it is important for
them to consider whether the controls implemented are cost-beneficial. In order for a
control to be effective, it cannot place an undue burden on the operation of the
business. If the cost of implementing a control is greater than the cost of the possible
error or fraud it helps prevent or detect, then the control is not efficient. However, the
cost of possible fraud losses should not be underestimated. With each suggested
control, the owner must weigh the associated costs and benefits before deciding
whether it is effective and efficient for the company. For example, one recommended
internal control would require that receipts be provided to all customers. The
substantive cost to that recommended control would likely relate to the free meal and
$10 gift certificate that would be provided, if the customer failed to receive the
receipt. Another potential cost would be incurred if customers falsely claimed failure
to receive a receipt, when in fact the clerk provided the receipt. These costs would
need to be weighed against the benefit of a potential reduction of fraud.