1.

CASE STUDY T5-1: Senior officer’s statements

During a convention of a professional managers’ association, you heard the following comment
from RayAnne Sugarbaker, a senior officer of a large Canadian company:

“Internal auditors should not make recommendations to improve management systems and
practices. This is outside the scope of their work and can be detrimental to their independence.
Their job is to identify the problems; operational managers are to find the solutions. Managers,
not auditors, are morally responsible for the operation of their divisions. Besides, auditors do not
have the expertise to determine what corrective action should be taken by management.

By making recommendations, auditors also hinder their effectiveness. How can they subsequently
review, in an objective manner, systems and practices that they recommended be implemented?
This is a direct threat to their independence.

I heard a lot about auditors trying to determine the causes and effects of deficiencies in
management systems and practices. They cannot and should not do that. In our company,
internal auditors are forbidden to make recommendations. As I have always said, let the
managers manage and the auditors audit.”

Required

Write a response to RayAnne’s statement. In your response, discuss why you agree or disagree
with each of the points she raised.
2. CASE STUDY T5-2: Doran Ltd.

Jack Newcombe, CGA, is director of the internal audit department of Doran Ltd., an important
Canadian manufacturing company. The president of the company walked into Jack’s office this
morning and made the following statement:

“Jack, I just got a phone call from the vice-president of finance concerning a major fraud that has
been committed by one of the purchasing agents in our procurement department. It seems that
the agent has misappropriated over $200,000 in the last three years. The details on how the
fraud has been committed are unknown.

I am disappointed that your department has not detected this fraud. The procurement
department is one of the most important departments of the company, and you perform a
detailed audit of these activities every year. In fact, the last audit was conducted only six months
ago.

I will have to bring this matter to the attention of the audit committee, which meets in two days.
The committee members will certainly be interested to know why the internal audit department
has not detected this fraud. Some members consider that the detection of fraud is one of the
most important responsibilities of your department and may believe that you are not doing your
job well.

I think that you should attend the audit committee meeting and prepare yourself to answer their
questions. We will not have time to obtain more details about this fraud before the meeting. It
would be a good idea, for now, to stick to general points. I would like you to make a short
presentation to the committee members on the responsibilities of the internal audit department
regarding the deterrence, detection, investigation, and reporting of fraud and present any other
relevant points to explain why the fraud has not been detected through internal audits carried
out in the procurement department. Before the meeting, I would like to review with you the main
elements of your presentation. Prepare your notes, and let’s meet in my office at ten o’clock
tomorrow.”

Required

Assume the role of Jack Newcombe and prepare your notes for the meeting with the president.

3. CASE STUDY T5-3: Big City

You are a supervisor in the internal audit department of Big City. Your department has included
the fleet management division of Big City in its audit plan for the current year.

Big City owns over 3,500 cars and trucks. Every year, approximately 700 vehicles are traded or
disposed of. The fleet management division is entirely responsible for the management of all
vehicles from their acquisition to their disposal.

During the planning phase of the audit, you noted that the division’s policies and procedures
manual included a section on disposal of vehicles. The policy states that the division should
determine the estimated useful life of each vehicle, in kilometres, and that each vehicle should be
disposed of when a certain number of kilometres travelled is reached, providing that the
accumulated repair costs of the vehicle (excluding normal maintenance) are equal to or greater
than 50% of its original acquisition cost. Repair costs and kilometres travelled for each vehicle
should be ascertained and recorded in the vehicle service ledger of Big City. Vehicles not required
for continuing service should also be disposed of. The objective of the audit of the fleet
management division is to determine whether dispositions of vehicles are made in such a way as
to maximize the benefits to Big City — that is, with due regard for economy, efficiency, and
 effectiveness.

The audit criteria for the audit have been established as follows:

Dispositions of vehicles should be made in accordance with Big

City policies and procedures.
The vehicle service ledger should be complete and
accurate. Dispositions of vehicles should yield
maximum benefits to Big City.

Required

Prepare an audit program for Big City. Be sure to follow the format provided to you
in Reading 5- 4 in identifying division, audit objective, the three audit criteria, and
audit procedures. In identifying audit procedures, consider first the type of evidence
required by the auditor to determine whether the criteria are being met. This will
enable you to determine the appropriate audit procedures.

QUESTION

ERT Ltd. is one of the largest Canadian manufacturers of silicon chips. The company grew
quickly but because of the large amounts of money that it had to invest, its cash reserves were
quickly exhausted. ERT therefore applied for, and obtained, sizable grants from the various
levels of government anxious to foster the development of high-tech companies. However, the
grants were accompanied by conditions that the company must comply with annually for a 5-
year period starting January 1, 2018. If, at the end of a fiscal period, the conditions are not met,
ERT will have 5 years to repay all grants obtained.
These conditions, while known and accepted by the board of directors when the agreements were
signed, are a little worrisome to the company’s vice-president of finance. These conditions affect
certain areas of the company’s operations that have always been weak, as identified below.
The following two conditions are especially troubling to the vice-president of finance.
1. Art. 15(a)
Inventories
The corporation shall at all times maintain raw material and finished goods inventories at market
value equal to or greater than 50% of the total amount of grants obtained.
2. Art. 18(c)
Other expenses
The corporation shall exercise control over its expenses other than those directly related to
manufacturing. These expenses include the salaries of senior executives, all managers except
production managers, and administrative staff. They also include the company’s financial
expenses. These expenses cannot exceed 45% of total expenses and costs of any type incurred by
the corporation for a given fiscal period. As a management auditor for the company, you are well
aware of the weaknesses that worry the vice-president of finance and you entirely share his
concern regarding the company’s ability to meet the conditions laid down by the granting
agencies. During the past year, ERT has experienced several stock-outs that resulted in the loss
of a number of large clients. Despite the efforts made by the sales department, the company has
not been able to win back some clients who switched to ERT’s competitors.
You are reviewing the annual audit plan and you realize that the audit of finished goods
inventories might cause you a problem. The most valuable items are generally too small to be
counted manually and you will therefore have to use specialized equipment to determine the
value of these inventories. Another problem is that all the items appear similar, whereas their
values may differ considerably.
When questioned on this subject, the vice-president of production tried to reassure you:
“We already have the equipment needed to determine the value of the inventories. In fact, I
am surprised that you were not aware of this, considering that we have been using this
equipment for more than 5 years. You can stop worrying; I know the value of every item
produced in this plant.”
As to the reduction of expenses, you have no idea where to begin. The other-expenses-to-total-
expenses ratio is currently 53%, and an 8% reduction seems impossible to you. Also, you have
noticed that since it was announced that grants had been obtained, other expenses have risen
substantially. The chief audit executive (CAE) is well aware of the problems that could result
from a failure to meet the conditions imposed by the different granting agencies. She therefore
advised management to introduce performance incentive programs for the managers responsible
for activities that may affect other expenses.
The board of directors quickly agreed to the CAE’s suggestion and approved a remuneration
policy for the managers concerned. Here is an excerpt from the new policy:
As a special bonus, the vice-president of production will be granted a lump sum equal to 20%
of her regular salary if, at the 2006 fiscal year end, inventories of raw materials and finished
goods are equal in value to at least 50%, and no more than 55%, of the grants obtained by
the company. The bonus is valid only for the 2006 fiscal year and is not proportional.
As a special bonus, the vice-president of purchasing will be granted a lump sum proportional
to the reduction in the other-expenses-to-total-expenses ratio. The bonus will be calculated by
applying, to the regular salary of the vice-president of purchasing, a percentage equal to the
percentage reduction in the other expenses ratio. The bonus paid cannot exceed 10% of the
regular salary. The bonus is valid only for the 2006 fiscal year.
You are surprised by the speed with which this new policy was implemented and you wonder
whether all its possible effects have been identified and analyzed by management and submitted
to the board of directors for approval. As well, you do not know whether this new policy is
adequately supported by existing policies and procedures. You also wonder about the possible
impact the policy might have on the internal audit of the units concerned.
The CAE, to whom you have confided your concerns, considers it essential to amend the annual
audit plan to ensure that the conditions imposed by the granting agencies are met. However,
before the plan is amended, she would like you to write a memorandum proposing a series of
criteria and procedures for ensuring that the objective of complying with the conditions is met.
She would first like you to develop the audit criteria and procedures that would apply to the
following:
1. Production
2. Inventory management
3. Purchasing
4. Administrative expenses
5. Remuneration management
6. Treasury
As well, the CAE would like your opinion on the effect the remuneration policy might have on
the company’s employees. In closing, the CAE reiterates that the criteria and procedures you
propose must focus strictly on elements that relate to compliance with the conditions associated
with the grants.
Required
Write the memorandum to the CAE.

PART 1

Case study Question Connon Chemicals Inc.

Background information

Connon Chemicals Inc. is a major manufacturer and distributor of specialty chemicals used in the
manufacture of newsprint and other paper products. The company has three plants, two in Eastern
Canada and one in British Columbia. It develops new products that have received a reasonable
degree of acceptance among paper producers in Canada and more recently in the United States.
Most of Connon’s chemicals are manufactured at the company’s three Canadian plants. There are
increasing instances where this is not feasible.

Some products are produced by relatively low-tech mixing and blending (as opposed to reactive
chemistry) and are provided to the user as a suspension or solution, containing a high proportion of
liquid, often water. The costs of shipping such products to customers located some distance from
the company’s plants (such as customers in the south-eastern United States) means that the
products cannot be priced competitively compared with locally-manufactured near substitutes. Even
though the company’s products are preferred by the paper companies, economics forces them to
purchase less effective chemicals from other companies.

In such circumstances, the company has contracted for toll manufacturing of their products by
chemical companies located closer to the end-user. Connon orders the raw materials for delivery to
the toll manufacturer’s plant and the toll manufacturer blends the raw materials to produce the
specialty chemical, using Connon’s formulation. Customers place their orders with Connon’s order
desk, and Connon’s staff arrange with the toll manufacturer for delivery of the product to the
customer’s mill. Connon invoices the customer. The toll manufacturer is paid a small warehousing
fee for maintaining the inventory of Connon’s raw materials and finished goods, and is paid a fixed
rate per pound (or kilogram) for blending and shipping the product.

The vice-president of production has just met with the chief audit executive at Connon. The VP
said that he was concerned because the number of toll manufacturers and the volume of
production that they were undertaking had increased dramatically in the last year. He was aware
of some of the risks of using outside blenders and wanted the internal audit department to carry
out a risk-based audit of the use of toll manufacturers. He suggested that since 30% of such
production was done through one such company (Cajun Chemicals in Baton Rouge, Louisiana),
that company might be the focus of the audit.

Required

1. List the risks that Connon Chemicals is exposed to when using outside toll
manufacturers. Which of these risks poses the greatest risk to the company’s
achievement of its objectives?
 2. Establish the scope and objectives for an audit of the company’s toll manufacturing
activities, focusing on its use of Cajun Chemicals.

3. Hint: Consider the background information provided, and prepare a list of the risks
that you can identify with the use of toll manufacturers by Connon.

PART 2

Case study Question : Connon Chemicals Inc. (continued)

Required

Part a

For each risk identified in the solution to the case study given in Topic 4.8, determine the
controls (or other means of mitigating the risk) you would expect to find.

Solution (a)

Part b

State appropriate criteria to evaluate the company’s efforts to address each risk, and
develop an audit program for your audit. Remember that the criteria and audit program
must be designed to achieve the scope and objectives set out in the solution to the first
part of this case