Case Study: Internal Controls and F

Case Study: Internal Controls and Fraud (From IIA Research Foundation "Case Studies in Internal Auditing" Volume 4)

Standards and Ethics

Please note there is no one right answer for these assignments. You should consider different points of view on the ethical issues before drawing your conclusions.

Objective

This case study is designed to expose students to a variety of conditions that may or may not indicate a fraud has been committed. Consideration must be given to errors that are present in a normal business environment, internal control weakness accepted by management, as well as obtaining an understanding of procedures and their long-range effect on business. Control weaknesses by themselves are not major problems. The combination of the control weaknesses, coupled with the inexperience of the internal auditor and a limited audit budget present real life situations. Students need to understand the overall control environment and not just deal with individual procedure errors.

Control weaknesses by themselves are not major problems. The combination of the control weaknesses, coupled with the inexperience of the internal auditor and a limited audit budget present real life situations. For example, does the auditor know when to expand an audit test, discontinue tests, and ask for additional data? What information is needed, who should respond, and what reliability should be placed on the information? Does the auditor know what is necessary to support an audit recommendation or, more importantly, to provide evidence in a criminal case?

Required

Please read all of the requirements carefully and make sure your paper addresses each item. It would be helpful for your own use to develop a high-level process map. This assignment is to be completed using only the materials authorized for use in this class. A rough guideline to adequately complete the assignment is 5-6 single-spaced pages. If you have any questions as to what is expected, please contact the instructor.

1. If you were part of the audit team, what additional questions would you ask to gather more audit evidence? You need to focus on what is most important to this case. You must come up with at least 15 relevant questions. You must have some questions for each of the five areas: receiving, loom teardowns, customer orders, disposal of residues and scrap metal, and administration of the loom reclamation program. You must indicate what you hope to learn from each question (i.e., what is the intent of the question?) and to whom the question would be addressed.
2. Identify your top four internal control weaknesses in order of materiality in each the following five areas: receiving, loom teardowns, customer orders, disposal of residues and scrap metal, and administration of the loom reclamation program. Please make sure you address the most important control weaknesses.
3. For each observation identified in #2, write your recommendation(s) to strengthen internal controls over the loom reclamation program. Make sure each recommendation is clearly associated with an observation(s) from #1. One recommendation can cover several internal control weaknesses.
4. In your opinion, has a fraud been perpetrated? If so, what evidence supports the allegation? Is it firm enough to convict the person(s) in court? Please explain the rationale for your conclusions.




Background

Many of Tarheel Textiles' old Draper looms have recently been replaced with more modern and efficient weaving machines. Instead of being junked or scrapped, these surplus looms are sent by the plants to the supply support division where they are stripped of all useable parts. These parts are reconditioned, stored, and placed on perpetual inventory records as used supply items.

Manufacturing facilities within Tarheel route all of their purchase orders for Draper loom parts through the supply support division. This includes orders made out to Draper Company and all other vendors from whom Draper parts can be purchased. Supply support reviews its inventory records (and will hold the order for no more than one day) to determine the availability of used parts generated from the loom stripping program. If parts are available within Tarheel, the purchase order to the vendor is altered and the supply support division ships the available parts automatically to the ordering plant. The altered purchase order is then sent to the vendor.

This program has resulted in substantial savings to Tarheel. Also, many of these older parts are in short supply and are, therefore, difficult to obtain within a reasonable delivery time.

Operation

The loom reclamation program operates as follows:

Receiving:

1. Plant sends to the supply support division all surplus Draper looms. These looms may or may not be operative, but would have been scrapped at the plant, or otherwise disposed of, had they not been shipped to supply support.
2. Plant prepares a shipping document, which accompanies each shipment of looms. This shipping document lists each asset shipped, identified with the Tarheel fixed asset tag number.
3. The shipping plant prepares the necessary reports to transfer these surplus items to the supply support division fixed assets ledger.
4. The looms are transferred, unloaded, and placed in a 3-1/2 acre fenced-in field.
5. Shipping documents are sent to the administrative office, where looms listed on the shipping document are compared to the quarterly printout received from corporate accounting which lists all assets transferred to supply support during the quarter.
6. The administrative area keeps a manual listing of looms. This list is reconciled quarterly with the computer-generated fixed asset ledger received from corporate accounting.

Loom Teardowns:

1. Looms are torn down daily (as many as time permits). The teardown process includes:
- Removing the Tarheel Textile asset tag number.
- Stripping the asset of all useable parts.
- Reconditioning these parts.
- Storing any salvageable metal and the residue (or carcass) in a central area. The residue is usually loom frame and some useable pieces of metal.
2. A loom teardown report is prepared weekly. The report lists by identification tag number each loom torn down during the week. Sometimes, however, tag numbers are missing from the looms--many of the looms are old and thus the tags have been jarred loose or have fallen off during shipment.
3. This report is sent to the administrative office where it is used to authorize removal of these looms from the fixed assets accounting records. The tag number identifies assets on the ledger.
4. The loom parts salvaged as a result of the loom teardown are collected. A quality control person reviews each part to determine whether it is reusable as is, needs to be reconditioned, or should be sold as scrap metal. The reusable parts are eventually sent to the supply room and placed on perpetual inventory records for accountability.

Sale of Reconditioned Loom Parts:

Written Customer Orders:
1. The computer generates a shipping document based on a written customer order. The customer may be a Tarheel Textiles plant or another company.
2. The shipping document is reviewed in the supply room. If inventory records indicate reconditioned Draper loom parts are available in bins, these parts will be used to fill the order. If inventory records show no parts available, the supply room clerk copies these part numbers/descriptions on a sheet of paper.
3. This sheet of paper goes to the loom teardown supervisor. Crew members will go out to looms in the field and strip the needed parts from the looms.
4. These parts are sent to the supply room, along with the piece of paper, for review and to make ready for shipment.
5. The shipping supervisor loads goods onto the truck. He checks against notice of shipment to assure accuracy of loading.
6. The loaded truck leaves premises.

Telephone Orders:
1. Verbal orders received from customers, either by the supply room or the loom teardown supervisor, are handled similarly except that no written customer order exists. All information is written on an order form
2. The two supervisors coordinate selection of parts, either from supply room bins or stripped from looms in the field.
3. After the parts have been pulled and the order is ready for shipment, the supply room supervisor contacts the administrative area so that a shipping document may be prepared, based on the items listed on the order form.
4. The shipping document is sent to the shipping supervisor.
5. The shipping supervisor loads goods onto the truck. He checks against the notice of shipment to assure accuracy of loading.
6. The shipment leaves the premises by Tarheel Textile truck, customer truck or common carrier.

Disposal of Residues and Scrap Metal:

1. The loom teardown supervisor usually receives customer orders verbally. Johnstone & Company is the primary customer to whom Tarheel sells loom residues and scrap metal. A company representative will often come to Tarheel, select loom residues and scrap parts he wants to purchase from those available, and supervise the loading of his truck.
2. The loom teardown supervisor calls the administrative area and requests a shipping document be prepared since company policy prohibits any vehicle from leaving the premises without a notice of shipment. The supervisor gives the office all the information necessary to prepare the document.
3. The truck leaves the premises from the loom field through the main gate.

The Telephone Call

Mr. Arthur Thomas, the buyer in corporate purchasing responsible for the disposal of Tarheel Textiles' surplus assets (including the sale of all parts from the supply support division), received a telephone call from a person who stated he had previously worked for Tarheel Textiles. The caller alleged that the supervisor of the loom teardown program at Tarheel's supply support