Module 7 (Internal Control and Control Risk)

Problem 7-1:

1. Company separates cashier with data entry for cash receipt and sales.
• Control activities
2. Senior management obtains data about external events that might affect the entity and
evaluates the impact of that information on its existing accounting processes.
• Risk Assessment
3. For effectiveness of internal control, management active deal with periodic
assessment the quality of internal audit which internal audit with performed by
independent staff both the operating and accounting department.
• Monitoring
4. The board of the company creates an audit committee that is in charge with oversight
responsibility for financial reporting.
• Control Environment
5. Before a cash disbursement can be processed, all payee information must be verified
by matching the payee to the company’s approved vendor listing.
• Control Activities
6. The system automatically reconciles the detailed accounts receivable subsidiary
ledger to the accounts receivable general ledger account on daily basis.
• Information and Communication
7. The audit committee’s independence (integrity and ethical) from management and of
financial reporting issue to determinants of its ability to effectively evaluate internal
control (competence) and financial prepared by management.
• Control Environment
8. The company has an organizational chart that establishes the formal lines of reporting
and authorization protocols.
• Control Environment
9. The sales accounting system should be designed to ensure that all shipment of goods
are correctly recorded as sales and are reflected in the financial statement in proper
period.
• Information and Communication
10. The compensation committee reviews compensation plans for senior executives to
determine if those plans create unintended pressures that might lead to distorted
financial statements.
• Risk Assessment

Problem 7-2:

a)

• Operations : Relating to effective and efficient use of the entity’s resources

• Financial reporting: Relating to preparation of reliable published financial statements
• Compliance: Relating to the entity’s compliance with applicable laws and regulations
• Safeguarding of assets: Relating to the safeguarding of assets against unauthorized
acquisition, use or disposition.
b)

Problem 7 – 3
Worked, Ltd, is a Japanese electronics games and amusements company specializing
in pachinko games. Pachinko parlours are a big industry in Japan, whose 18,000 pachinko
parlours in 1996 accounted for a quarter of the country’s civil sector and are thought to
produce Japanese Yen 30 trillion per year in revenue – more than Japan’s auto industry.
Customers who play pachinko buy a supply of pinballs costing around 4 Yen and cash in the
balls they win back for prizes equivalent to 2.5 Yen each. Although it is illegal to give cash to
winners, the customers may go to nearby shops and sell their prizes for cash. Recently a new
form of pachinko has been developed that gives very large prizes to winners, but decreases
the chances of winning. Although the number of players has decreased over the last four
years, the gross sales have doubled. Location of the stores is not crucial, so Worked, Ltd. can
locate in low-rent areas.
Government authorities have recently given much attention to pachinko gaming.
Operations featuring the game have been associated with the yakuza, the Japanese criminal
organisation. Some people in Japan are concerned that pachinko is really addictive gambling.
There are complaints to authorities over children being left to play on busy streets or locked
up in parked automobiles while their parents go to play pachinko.

Required:
Following the five-step procedure outlined in the chapter, identify the risks associated with
Worked’s business.

1. Identify the essential resources of the business and determine which are at most risk.
The essential resource of OK Yen is their right to operate openly to an unrestrained
customer base (Pachinko players). Because Pachinko parlours are gambling institutions
that may be supported by criminal activity (Yakuza) and there is public opposition to
them, there is a possibility that Pachinko parlours may be closed by the government.
2. Identify possible liabilities which may arise. There are both legal and civil liabilities
that might affect OK Yen.
a. If the authorities declare these enterprises illegal, owners and management might be
subjected to incarceration in prison.
b. If the government continues to allow operation, the operating environment may be
changed drastically by partial restrictive methods such as limited hours or taxes.
 c. OK Yen may be subjected to suits by civilians claiming that their operation
indirectly causes death of children by encouraging their parents’ addiction to
Pachinko.
3. Review the risks that have arisen in the past. There seems to be a long-term decline in
the number of players, even though sales have doubled. To stop the reduction in players
indicates that OK Yen should take appropriate measures to stop the slide. Too rapid an
increase in sales without increases in the number of customers may cause problems.
4. Consider any additional risks imposed by new objectives or new external factors.
The new form of Pachinko that decreases the chances of winning but increases the size of
the prizes makes the Pachinko playing more substantively like ‘real’ gambling. This new
innovation may give the government an excuse to declare the games as illegal gambling.
5. Seek to anticipate change by considering problems and opportunities on a
continuing basis. There is no indication that the management of OK Yen has done much
planning to anticipate change.

Problem 7 – 4
An example of a lack of internal controls with a disastrous result was the bond trading
loss in the New York Office of Empire Bank in 1995. Over 11 years 30,000 unauthorized
trades were made resulting in a $1.1 billion loss (an average of $400,000 in losses for every
trading day). Empire allowed Toshihide Iguchi, a bond trader, to authorize sales, have
custody of the bond assets and record these transactions.
As a novice trader Iguchi misjudged the bond market, racking up a $200,000 loss. To
raise cash to pay Empire’s brokers, Iguchi would order Bankers Trust New York to sell bonds
held in Empire’s account. The statements from Banker’s Trust came to Iguchi who forged
duplicates, complete with bond numbers and maturity dates, to make it look as if Banker’s
Trust still held the bonds he had sold. When he confessed to his misdeeds, Empire thought
their bond account was $4.6 billion when in fact only $3.5 billion was left.
Inadequate review of internal controls was also to blame. Empire’s internal auditors
had reviewed the New York branch several times since the fraud began, but Banker’s Trust
was never contacted for confirmation of Empire’s bank statements. If they had, Iguchi’s fraud
would have been exposed. Empire’s external auditor never audited the New York branch.

Required:
A. What type of control procedures were ignored at Empire?

All control procedures were ignored at Empire:

• Separation of duties of custody, recording and authority were not separated.
• The trades and access to Banker’s Trust should not have been authorized to Iguchi.
(there should be another person/staff/employee/senior to authorize the transaction).
• Documents were forged.
• Iguchi had absolute control over assets and records. (the custody should be handled by
someone else)
• There was no independent check on performance.

B. For each internal control procedure missing, what damage was caused?

• Lack of separation of duties encouraged and resulted in fraud.

• Uncontrolled authorization made it easy for Iguchi to trade and control assets of any
amount up to the total assets of Empire (missappropriation of assets).
• Access to documents and no proper controls lead to forgery.
 • Unlimited access to bonds leads to misappropriation.
• Lack of independent checks allowed the fraud to go unchecked for eleven years,
and it could have been longer had Iguchi not confessed.

C. What kind of controls could have been instituted what would have prevented the
problems at Empire?

To prevent the problems at Empire there should have been separate individual’s
responsibility for trading, recording and custody. Independent checks (auditor can also do
confirmation to third party) would have discovered the problem earlier and exposed the
Bankers Trust statement forgery.

D. For each of the five internal control procedures discussed above, applying each to a
bank trading operation, identify a specific error that is likely to be prevented if the
procedure exists and is effective!

Applying each of the five internal control procedures to a bank trading operation, errors that
are likely to be prevented are as follows:
• Adequate separation of duties would prevent overtrading and unauthorized
commitment of money.
• Proper authorization of transactions and activities would control traders and reduce
risk.
• Adequate documents and records; from both internal and external sources would
have shown the deficit.
• Physical control over assets and records would reduce the chances of losing money.
• Independent checks on performance would keep traders honest and discourage
fraud.