Background - Understanding of the Control Environment

Ownco, Inc. (Ownco) manufactures plastic fishing worms at one location (Running Water, Arkansas). Ed Jones, its sole owner, manages Ownco. Jones is responsible for marketing, purchasing, hiring and approving major transactions. He has a good understanding of the business and the industry in which it operates. Jones believes that hiring experienced personnel is particularly important because there are no layers of supervisory personnel and thus, because of limited segregation of duties, few independent checks of employees' work. Jones has a moderate-to-conservative attitude toward business risks. The company has demonstrated consistent profitability, and because Jones considers lower taxes to be as important as financial results, he has a conservative attitude toward accounting estimates.

Jones and Pat Willis, the bookkeeper, readily consult with our firm on routine accounting questions, including the preparation of accounting estimates (tax accrual, inventory obsolescence, or bad debts).

Family members compose the company's board of directors. The board does not monitor the business or the owner-manager's activities.

Pat Willis performs most of the significant accounting functions while Chris Ross, Ed Jones' secretary, opens the mail including checks received. The company hired Willis ten years ago. She has a working knowledge of accounting basics, and we have no reason to question her competence. Willis regularly consults with our firm on unusual transactions, and history shows that it is rare for adjustments to arise from errors in the processing of routine transactions.

The owner-manager, Ed Jones, carefully reviews computer-generated financial reports, such as reports on receivables aging, and compares revenues and expenses with prior years' performance. He also monitors the terms of the long-term debt agreement that require certain financial statement ratios and compensating balances. Based on our firm's experience with the client, we have noted that management override of internal controls is NOT a concern.

Ownco uses late model, Windows-based, networked, microcomputers. The company uses a basic accounting software package (QuickBooks) that provides for three users. The source code is not available for this software. A network printer was purchased with the computers. The network maintenance and setup is outsourced to Digital Tech, Inc. and is properly controlled so that only Willis, Ross and Jones have access to the accounting system. Digital Tech, Inc. provided our firm with a copy of a CPA's report on the effectiveness of its controls over the privacy of the information it processes for Ownco, Inc. Our firm also has been granted “reports only” access (cannot edit or change any transactions) to Ownco's QuickBooks Pro^™ accounting system. The backup for the accounting and company files is also done automatically and regularly, and stored offsite by Digital Tech, Inc. For the computer controls, Jones is set as the master administrator of the accounting system, with Willis as the company administrator. That means that Jones can change who has access to any part of the accounting system while Willis has access to all the accounting system processes. Ross only has access to cash receipts recording but does not have access to the general ledger, cash disbursements, nor purchases. From an audit perspective, the computer environment is determined to be simple (not complex) and IT audit is not necessary. The IT environment does not provide any concerns from an audit perspective about the computer accounting software and related computerized accounting controls. Our completed Computer Processing Overview questionnaire follows.

Sales Stream in Revenue Cycle:

Sales in the current year ending September 30, 20XX were approximately $10,300,000. The number of transactions was approximately 35,000. At the time a sale is made, the sales representative enters information such as customer name and number, shipping and inventory description, stock number, and price on a four-part, pre-numbered sales order (SO) form. Written explanations of price variances are attached.

The owner-manager (Ed Jones) reviews each SO for pre-numbered sequence and proper price, approves the extension of credit to the customer, and signs the sales order. The bookkeeper receives SO copy No. 1. The warehouse, the sales representative, and the customer receive the additional copies. Mr. Jones reviews sales orders after the fact on return from being away from the office.

The bookkeeper receives approved SO copy No. 1 from the owner-manager and files them numerically, pending receipt of the shipping report.

Upon receipt of SO copy No. 2, Jack Trout, the warehouse supervisor, ensures that the owner-manager has signed the SO and then has the warehouse pickers, John Amos and/or Robert Deal, pull the goods and prepare the shipping report.

The shipping clerk, Jeff Tanner, receives the shipping report, SO copy No. 2, and the pulled goods from the warehouse. Jeff Tanner verifies that the goods agree with the SO and the shipping report, initials the shipping report, prepares the goods for shipment and ships the goods. The bookkeeper receives the shipping report and matches it with SO copy No. 1. Copies also go to the customer and to the warehouse supervisor (for filing in the warehouse department). The bookkeeper enters stock number, quantity, prices, and customer information into the microcomputer.

The computer prints sales invoices. The bookkeeper matches computer-generated sales invoices with sales orders and shipping reports for completeness. The bookkeeper also investigates unmatched sales orders and shipping reports monthly. The customer receives the original sales invoice (including a breakaway remittance advice).

The matched sales order, shipping report, and sales invoice are stapled together and filed by sales invoice number.

At the end of the day, transactions are posted to the cumulative sales master file, the accounts receivable master file, and the general ledger. The owner-manager reviews sales reports and shipping reports weekly. The owner-manager reviews the aged trial balance twice monthly, and he follows up on past due accounts. The owner-manager pays particular attention to accounts over thirty days past due.

Customers receive statements each month. The statements request the customers contact Mr. Jones, the owner-manager, for any disputed balances.

The bookkeeper reconciles the accounts receivable subsidiary ledger and cumulative sales master file with the appropriate general ledger accounts monthly.

Cash Receipts Stream in Revenue Cycle

Chris Ross, the secretary, receives all checks and remittance advices. She prepares a complete listing of all checks received. She retains the original list, and gives a copy to Pat Willis, the bookkeeper, along with the checks and remittance advices.

Willis prepares the bank deposit and adds the account code to each item listed on the listing of checks received. She makes the bank deposit, and then gives Ross a copy of the deposit slip, receipted by the bank. Ross then compares the deposit slip with the original list of checks. Willis enters customer and cash receipts information into the microcomputer using the listing of checks with account codes. Willis runs the program that updates the accounts receivable master file and cash receipts file daily. Transactions are posted to the general ledger at the same time. The cash receipts journal, subledgers, and general ledger are printed on demand. Willis compares the computer-generated accounts receivable subsidiary ledgers with the general ledger control account monthly. Willis also prepares the bank reconciliation monthly, which Jones reviews.

Materials and Instructions

View the following videos:

• Internal Control Structure Concepts PowerPoint video.mp4

• Transaction Errors and Management Assertions PowerPoint video.mp4

Download and use the Excel spreadsheet, Ownco1.xlsx, to document and complete your internal control evaluation assignment. Documentation for the sales stream in the revenue cycle is already mostly completed and found in the Ownco1.xlsx Excel spreadsheet.

Also, download and view the following videos to help you complete the assignment:

1. Ownco Assignment Overview and Data File.mp4

2. Documenting Accounting Processes for Ownco Case Excel Version.mp4

3. Documenting Controls Part 1 for Ownco Case Excel Verstion.mp4

4. Documenting Controls Part 2 for Ownco Case Excel Version.mp4

5. Select Key Controls and Make Preliminary CRA for Ownco Case Excel Version.mp4

6. Documenting Ideal Controls for Ownco Case Excel Version.mp4 (for Part II)

Required

Objective: Part I Actual: Learn how to document and evaluate an entity's internal control structure.

1. ICE Step 1, evaluation of internal control environment, has been done. It has been determined that management override is not an issue and the computer processing for this small company provides enough foundation for reliance on computerized accounting controls. In the Ownco1.xlsx spreadsheet relate the sales stream information to the documentation about the sales stream found on Ownco1.xlsx. The sales stream is a model or pattern you can use to help you document the cash receipts stream.

2. Document the accounting processes, controls, and make your preliminary Control Risk Assessment (CRA) using the Excel file Ownco1.xlsx for the cash receipts stream:

   1. ICE Step 2: Document the accounting processes in the cash receipts stream: Using the flowchart screen and Excel's flowcharting tools, add the cash receipts stream process symbols to the revenue cycle overview flowchart you believe are necessary to adequately document the cash receipts accounting processes. (Use the sales stream flowchart as a model for how to complete the overview flowchart.) Document only the processes, not the controls. Also, in the process and control summary worksheet list each accounting process you added to the overview flowchart and fill out the columns about personnel performing each process and whether the process is manual or computerized.

   2. ICE Step 3: Document the controls in the cash receipts stream. Make sure to include the accounts receivable general ledger (AR GL) because it is in both the Sales and Cash Receipts stream. Using the Process and Controls Summary tab in the Ownco1 worksheet, fill in the table based on the Sales and Cash Receipts narration concerning the controls. The columns are as follows:

      • Control name(s) (if any controls exist) for each process.

      • Management Assertion(s) for each control.

      • Person(s) performing control.

      • Is the control preventive or detective?

      • How is the control documented?

      • Compensating control (if any) - A compensating control is a control later in the overall processing that “compensates for” the lack of any controls for a particular process.

      • Location of each compensating control – What accounting process does the compensating control protect?

      A list of controls and the list of management assertions and the related descriptions of the controls and assertions are found in other worksheet tabs in the Ownco1 spreadsheet. Make sure you complete all the columns for the controls.

   3. ICE Step 4a: Make Preliminary CRA. Using the column for key controls in the Processes and Controls Summary worksheet tab, identify key controls for the cash receipts stream. Then review the key controls on the sales stream and make changes as you deem appropriate. Make sure you mark in the Process and Control Summary worksheet which controls you plan to rely on and test (i.e., which controls you select as key controls.).

   4. ICE Step 4b: Using the CRA worksheet tab, record the risk category you believe is appropriate given your documentation of the accounting processes and controls. Make a preliminary CRA on the Cash Receipts stream. The Sales stream is done as an example, but you may want to review it and change it if you wish based on your evaluation of the documentation. Your CRA will include the management assertions Existence / Occurrence, Completeness, Valuation-Gross, (Valuation-Net is not needed since we are not reviewing controls for allowance for doubtful accounts nor sales returns and sales discounts) combined into a management assertion group.

Finally, write a separate paragraph in a Word document for both the Cash Receipts stream and Sales stream, respectively, explaining the reasons you chose the CRA levels for each stream. Base your CRA levels on your understanding of the ICE structure as documented by:

• The accounting processes (designed well to mitigate errors in the accounting system)

• The control procedures and management assertions covered by each control (overall coverage)

• The number and placement of key controls that are in place

• The missing key controls

• Segregation of duties

Hand in Part I “Actual” Ownco documentation by uploading your Excel and Word files for the assignment in the online course management system. Save the files with an “A” and your last name and first initial. (The A stands for “Actual.”) Make sure your name is in the worksheet somewhere as the preparer.

Objective: Part II Ideal: Take the approach as if you were a consultant for improving the internal control structure of Ownco, Inc. Document a situation in which the controls would provide an “ideal” set of controls given the limitations of a small company.

Using the documentation files from Part I, update your set of controls to a set of controls that would be ideal. That is, provide for an ideal set of controls that would support “Limited or Low” control risk assessment without hiring new staff. Save your previous “actual” file as a new file with an “I” and your last name and first initial. (The “I” stands for “Ideal.”) Make sure your name is in the worksheet somewhere as the preparer. Also, include a document that outlines how to improve segregation of duties including separation of:

• Authorization of transactions

• Recording transactions

• Custody of assets

• Person performing control does not perform the process

Your write-up should not only include a discussion of principles regarding segregation of duties, but also be specific as to how segregation of duties was improved for this Ownco case. It might be most helpful to write a paragraph about each of the above parts of segregation of duties, and tell specific things Ownco, Inc. can do to improve its segregation of duties given the limitations of a small company.

Hand in “Ideal” Ownco documentation through an attached file in the online course management system. Name the file starting with an “I” then your last name and your first initial. Be sure to also hand in your segregation of duties write-up in a Word file.

The spreadsheet is patterned after an internal control documentation approach and software called INFOCUS developed by Grant Thornton LLP.