Case 2

Mark hobson is an internal auditor employed by comstock industries. He is nearing completion of an

audit of the Avil division conducted during the first five weeks of the year. The Avil Division is one of
three manufacturing divisions in comstock and manufactures inventories to supply about 50 percent
of comstock’s sales. In addition to the manufacturing divisions, comstock has two marketing
divisions (domestic and internasional) and a technical service division that offers worldwide
technical support. Each customer is assigned to the most suitable manufacturing division, which
functions as the supplier for that customer. The manufacturing division then approves the
customer’s credit, ships against orders obtained by the sales representatives, and collects the
customer receivables when due. This allows order-to-order monitoring of customer credit limits
againts customer orders received.

Two Potential Observations

Two item concern Mark. First, there was a matrial dollar amount of inventory of part number A2 still
carried on the Avil books at year-end, despite the fact that the fast-tac machining component in
which part A2 was used is now considered first generation and is no longer manufactured. Company
policy requires an immediate write-off of all obsolete inventory items. Second, some accounts
receivable still carried as collectible at year-end were over 180 days old. All receivables are due in 30
days, which is standard for the industry. Mark belives many of these old accounts are uncollectible.

The division managers administrative assistant, Brenda Wilson, performed the aging of accounts
receivable rather than the division accountant, as is standard practice. The division accountant
refused to discuss the circumstances of Brenda’s actions.

The Auditee’s Comments

Mark scheduled a meeting with Brenda to discuss his concerns.

“well, Mark,” Brenda responded, “i know that policy requires that obsolete inventories be written
off, but part A2 is just not being used at present. We might start to make those fast-tac components
again. Who knows? Wide tics are coming back again, aren’t they? Fast-tac could, too. There are
plenty of customers, especially in the third world, that are finding those second and third genration
machines pretty expensive to mantain. I mean there is a policy that states obsolete inventories
should be written off, but there is no policy defining an obsolete part.

“and as for those receivables,” Brenda continued, “ that is certainly a judgment call, too. Who knows
if those accounts will be collected ? we’re in a slight recession now. When things pick up, we’ll
probably collect a few. There isn’t even a policy in this division on writing off receivables. I checked.
Nothing says i have to write them off. So who are you to say i have to?”

“Brenda, be straight. You know those parts will never be used. And you know those receivables are
bad.”

“look, Mark,” Brenda finally bargained, ”it’s onnly two weeks from the close of the year. Let’s let
these items ride till after the close so that everyone gets their bonuses. Then, i promisse i’ll tahe a
fresh look at both inventories and receivables. I’ll write them down after down after year-end, after
the financial reports are issued. No one will know. And, after all, who’s to be hurt?’
The Division Manager

Mark continued his audit, drafted his report containing observations related to the inventory and
receivables, and reviewed the report with the division manager, hal Wright. Hal was visibility
disturbed.

“Gee, Mark, this couldn’t have come at a more awkward time. Our figures just passed muster by the
independent outside auditors. There was a guy out here for our inventory count in november and
Brenda already sent her apreadsheet on year-end receivables to corporate headquarters. No one up
there, in our group or on the CPA audit team, was the least bit critical. If you go raising a big stink,
particularly now, the independent outside auditors will catch us writting off inventory and
receivables, they’ll adjust profit, and and there will be hell to pay for all of us. And, Mark, this is no
clear-cut issue either. I mean, I can see how you can write a report calling for clearer policy, but not
one calling for specific writedowns. That’s way out of your jurisdiction. But still, i promise, we’ll look
at all this after our statements go to bed. Right now, i feel the managers of this division have worked
their hearts out and i intend to fight to protect what little bonuses they have coming. If we write
down as you suggest, those bonuses will go and the stockholders will lose too. Earnings per share
(EPS) will drop like a rock. They might even close this division. Now you don’t want that, do you,
boy?”

“well, Hal, I could word my observations as they are in the draft but include your response.” Hal was
suddenly angry. “what? And let the audit committee decide the issue? They have nothing to do with
this. They accepted the CPA’s report. If you want to make the audit committee happy, you’ll accept
it, too, and leave this adjustment stuff alone.”

The Internal Audit Director

Concerned, Mark delayed finalizing his report and discussed the draft with Gail Wu, director of
internal audit. Gail is not trained as an auditor and was promoted to director of internal audit from
corporate finance so that she might develop a better understanding of operating relationships. Still,
Gail is very smart and Mark has always respected her opinion. The discussion was by telephone, with
mark still at the Avil division headquarters and Gail at the corporate office.

“Mark, Hal is right. If you, in essence, blow the whistle on management bonuses this year, we can
kiss goodbye all the goodwill i’ve been struggling to build for this departement. It will all go out the
window.”

“i know you”ve been trying ot put us on a better footing, Gail, but Hal is interactable. As far as he is
concerned, the only observation he will accept in the report is that of deficient policy, with nothing
mentioned about the inventory or reveivables needing adjustment.”

“well, do what you have to,” Gail ended the discussion.” But I insist that you submit a report that Hal
agrees to and has signed. I don’t want to stir up hornets and then have to try to explain my loose
cannon to the board when everyone is howling about the bonus problem.”

A. Refer to the IIA’s code ethics. Identify three spesific rules of conduct relevant to this case.
Using the rules of conduct you identify as the context, discuss the ethical issues raised in the
case.
B. Discuss how the ethical dilemma Mark faces might have might have been avoided. In other
words, discuss specific things comstock’s management and/or the internal audit function
might have done to reduce the risk of such a situation arising.
C. Clearly indicate what you would do if you found yourself in Mark’s position. Briefly explain
why.