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ABC Retailers — Internal Controls

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ABC Retailers — Internal Controls

According to PCAOB Auditing Standard, Internal controls are the important

components of any business or organization. Any misconduct in these controls can cause huge

losses and complications to the business. Therefore, auditing these internal controls is essential

for every firm. Auditing the control analyzes any fraud or scam which occurred in the financial

accounts of the company. This saves the firms from corruption and bankruptcy (Jaehong, 2016).

Internal controls of a firm include several components that involve diverse operations of the

company. Analyzing deficiencies in these controls helps in improving business operations. For

effective internal controls, the firm needs to present true and fair financial statements of their

company.

Misstatements Made In the Company Financial Statement

This paper is based on a case of material weakness and negligence of ABC Company.

Company’s duty was to review all the information given by vendors and to transfer the

information to the accounts payable department. The assistant controller of the firm transferred

relevant information about the vendor’s bank accounts retail to the accounts payable personal.

But, the accounts payable personnel failed to verify the information and used false information

for approval and transfer.

The audit team identifies this material weakness and placed it under the section of

negligence as accounts payable personnel failed to fulfill his job. This negatively impacted the

accounts payable balance as the transaction was approved to the wrong bank account that caused

the company a big loss. This also impacted the reputation of the firm as the audit identified

failure in the company’s internal control.

Factors to be considered in evaluating the severity of deficiencies

(According to PCAOB Auditing Standard)

According to PCAOB Auditing Standard Identifying the severity in deficiencies of

internal controls is one of the most complicated tasks that the company faces[ CITATION PCA07 \l

1033 ]. An auditor analyzes the design of effectiveness in the internal control by examining the

person who manages these controls. The auditor should also analyze the level of competence that

the person puts in the internal controls of the company (Raiborn, 2016). The competence

includes the control objectives of the firm and the ability of personnel to identify fraud or error.

Any fraud or error in the internal control can cause misstatement or material deficiency. If an

auditor analyzes material deficiency in the internal control that means the personnel who is

managing this control is not effective in doing their job.

For determining the severity of the deficiencies in the internal control system the auditor

needs to follow certain factors. The first factor that the auditor should determine is the deficiency

of misstatement. Deficiency of misstatement refers to the financial statement of firms which

includes errors, fraud, and wrong information. Companies use wrong financial information to

attract investors towards their illegal company. In many cases, the severity of deficiency is

analyzed by analyzing the fraud in financial statements. Therefore, the auditor needs to analyze

the statements for detecting fraud and error.

Sometimes the deficiency of internal controls also depends on the operational

management of the firm. As if a deficiency in controls occur this means that the management

failed in detecting the fraud and all the strategies which were implemented for improvement also
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failed. In some cases, management is also involved in fraud therefore analyzing the competence

of management towards internal controls is also effective (Johnson, 2017). Analyzing the

number of frauds and errors in the internal control statement also helps in defining the severity of

control deficiencies. Therefore, it is also an important factor for an auditor to examine the

number of errors and fraud that occurred in internal controls.

Deficiency in Design and Operations (PCAOB AS 2201)

Deficiency in the controls occurs when the operations of the controls don’t allow the

person to detect or prevent misstatements. These deficiencies due to operations make difficulties

for employees in fulfilling their assigned task. According to PCAOB AS 2201, this causes loss to

the company as the management fails to achieve the goal of the company. A deficiency in design

occurs when the operators fail to control the internal components of the company as per its

objectives. Improperly designed controls also lead toward control deficiencies as this kind of

control faces difficulty in accomplishing the task.

In the case of ABC Company, the management ensures all the necessary controls which

were needed for proper bank transactions. The company’s planning was based on understanding

the internal control which was elated to cash distribution for preventing any error (Howell,

2016). This shows that the company made essential procedures for managing their cash

transaction processes. They also made effective procedures for processing the request to change

suppliers' or vendors' bank account.

According to the Assistant Controller, the accounts payable was estimated to follow some

major processes. These include the start of processing and discharge of paid invoices from the

vendor who requested a change of bank account. He initiated to call the vendor for verifying his
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personal contact information that he received from the invoice. After receiving the contact

information h wanted to verify the authenticity of the gathered information. The personnel

working in the accounts payable department also ordered to shift this information into rigid

document form. The Assistant Controller also notify the management of the firm about his

change of account policy.

Although Assistant Controller fulfilled his all duties by informing both Accounts payable

manager and personnel are about the back account change policy. The accounts payable manager

was also not involved in the misstatement. The fraud of $2 Million that the company faced was

due to negligence of accounts payable personnel. He failed to consider on enlists the changes that

he received from the assistant controller which resulted in an incomplete and inappropriate

statement of internal control (Keune, 2018). Therefore, the failure of the Accounts Controller to

adequately review the vendor change form was due to operational deficiency. The reason behind

this statement is that the internal controls of the company failed to identify or prevent errors.

Material Weaknesses in the Control System

Material weaknesses or deficiency occurs when the internal controls of processes of the

firm become ineffective. Internal controls are built to analyze or detect errors in the company

processes and when these controls failed to fulfill their objective this becomes a material

weakness. It occurs when the control processes fail to enhance the operational activities of the

company and causes difficulties for the management. In this situation, the auditors term internal

controls of the firm as a material weakness. As a result, the company’s financial information

because inappropriate and unreliable due to which investors prevent themselves from investing

in these firms. This causes company a huge loss in terms of finance and reputation.
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ABC Company developed a vendor change form according to which vendors can request

to change their bank accounts. This process was introduced for both old and new vendors this

process required the contact information and bank details of the vendors. The examination of this

information collected from the vendors showed fair reports and revealed that management

included correct data without errors. The contact information was added to the system before

adding the bank accounts details of the vendors. The internal auditor of the ABC Company

concluded that only five out of 105 vendors request to change their bank accounts was approved.

The assistant controller gathered all the information that was needed for approving this company

policy. The assistant controller of the firm wanted the account payable personnel to review and

confirm the authenticity of the information before approving any change. According to him, this

action would prevent the company’s internal controls from errors.

The accounts payable personnel ignored the remarks of the assistant controller and

accepted the change without any confirmation. This causes significant deficiency in the internal

controls of the firm. The audit showed that only five vendors completed the process of change

documentation while the remaining didn’t request to change their bank details. However,

accounts payable personnel presented a report which stated all 105 vendors completed the

documentation. This represented material weakness of the company’s control.

Information That ABC Company Will Disclose (SEC Regulation)

After the identification of material weakness, ABC Company will provide a piece of

detailed information on their functional operations, disclosure of risks, and their financial data.

Moreover, the company will be required to provide complete data on their operating leases,

gearing ratio including debt and equity. This will also include the company’s real obligations.
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The company is also expected to state their risks and lawsuit that they faced in recent months.

This information will help conclude whether or not management is involved in the fraud.

The company will be required to mention all the risks that they were facing including

their risk mitigation strategies. Even though the audit management team has direct access to the

company’s financial statement but the data which is related to risk is not disclosed in the

statements. The company is liable to provide an accurate balance sheet, cash flow statement,

income statement, changes in equity statement, and other relevant information. The audit team

will analyze the financial transaction of the firm in the recent months or years to analyze the

origin of fraud and material weakness.

The requirement of F 10-K states that ABC Company needs to disclose each accounting

policy, strategy, and practice. The company will be required to provide every warranty

information policies including the cost of implementing these policies. Moreover, the company is

obliged to provide all financial transactions to the audit team about their payments that they

made to vendors. The audit team will identify the accuracy of the company’s accounting policy

after examining the data. The audit team will require the company to explain the reason behind

all operations and results. It will also include a discussion about how companies raise funds for

their operations and how they spend money. This discussion will provide auditors the essential

information for understanding the company’s operations.

Obligation Auditors Have In Terms Of Communicating the Results

The auditor will report to Internal Control over Financial Reporting (ICFR) after

concluding a failure in the company’s internal control. The auditor should always communicate

his findings in written form to the management team and the audit committee. This report
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includes the significant deficiencies, material weaknesses, and all the internal control failures

which the auditor investigated. Securities and Exchange Commission (SEC) states that every

company should disclose its material weakness and internal control failure. Hiding these failures

from the public is considered illegal as well as fraud. Therefore an auditor is advised to represent

true and fair views on the company’s financial statements and internal controls.

Securities and Exchange Commission (SEC) requires companies to disclose their material

weakness and failure to them. Any company that faces failure in the audit report experiences loss

of investors and bad reputation in the market this also discloses the ongoing fraud in the firm. In

the case of ABC Company, the management needs to report their control failure under SEC 10-K

form. The failure occurred due to the negligence of accounts payable personnel. Auditor will

disclose this information in a written audit report under the section of negligence act and care of

duty.

What Should The Auditor Do?

It is a critical phase for any organization after they identified a material weakness in their

internal control. The process of auditing is vital for every company and it requires the firm and

auditor to disclose accurate information. If the auditor fails to fulfill their job accurately and

honestly it will impact other departments of organizations, other firms in the industry, and

investors.

In the ABC case, if the material deficiency is analyzed in the accounts payable

department. It is predictable that other departments also include some sort of material weakness

in their internal controls. This can cause more severe and huge complications for the company

and all the stakeholders related to the company. Therefore, for saving investors, customers,
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suppliers, and other stakeholders from this difficulty, it is vital and obligatory for the auditor to

represent only true and accurate information about the company. Any false statement in the audit

report is illegal and can destroy the career of the audit team.

Conclusion

Internal controls play important role in the effectiveness and success of any company. If

these components are working effectively the company will be able to achieve its goal without

any issue. If the internal controls fail to fulfill their objective the company experiences issues n

accomplishing its strategies. An audit is implemented to identify failure and material weakness in

internal controls. Audit reports show the current financial position of the company and also

presents flaws in the accounting policies of the firm.

References

Howell, J. ( 2016, January 19). Tips for evaluating internal control deficiencies. Retrieved from

https://www.workiva.com/blog/tips-evaluating-internal-control-deficiencies

Jaehong, L. ( 2016). The Effect Of Internal Control Weakness On Investment Efficiency.

Journal of Applied Business Research, Vol. 32 No. 3. Retrieved from

https://doi.org/10.19030/jabr.v32i3.9648

Johnson, L. A. (2017, December ). The Development of Internal Auditing as a Profession in the

U.S. During the Twentieth Century. Accounting Historians Journal, 47-67. DOI:

10.2308/aahj-10549

Keune. (2018). o managers make voluntary accounting changes in response to a material

weakness in internal control? Auditing: A Journal of Practice & Theory, 107-137.

PCAOB. (2007). AS 2201: An Audit of Internal Control Over Financial Reporting That Is

Integrated with An Audit of Financial Statements. Retrieved from

https://pcaobus.org/oversight/standards/auditing-standards/details/AS2201

Raiborn, C. ( 2016, December 29 ). The Internal Audit Function: A Prerequisite for Good

Governance. Retrieved from https://doi.org/10.1002/jcaf.22246