CASE 8-5

ELECTRONIC ENTERPRISES LIMITED

INTRODUCTION

This case study involves reliance on a budgeting and variance analysis system which is a management control system typical of larger corporations.

SITUATION

Electronic Enterprises Limited manufactures electronic components and is organised in a divisional structure. Each division has a divisional manager who is supported by a controller, production manager, human resources manager and sales manager.

AUDIT APPROACH

The audit partner has decided that the company's system for budgeting and monitoring performance against the budgets has potential both for effectively monitoring business operations and for detecting errors in the accounting information. This year, the plan is to gather evidence on this system.

The partner believes that the ability of a budgeting system to detect errors in the accounting records depends on the reasonableness of the budgets and the rigour with which variances are analysed and followed up. The partner feels confident that this system (if it is operation effectively) should detect most potential errors that relate to completeness, existence and accuracy.

INTERVIEWS WITH SENIOR MANAGEMENT

The audit partner has obtained a great deal of information during previous year's audits on how the company's senior executives control their operating and financial activities. He knows that the company has developed an elaborate budgeting and monitoring system. This system is developed on the principle of ensuring that here is specific managerial accountability for all controllable costs. Each division separates its fixed and variable costs and prepares detailed monthly budgets in which standards for variable expenses are set for different levels of production.

The audit partner and his senior manager meet with the vice president of finance and the corporate controller in the planning stages of the audit to discuss the planning of the audit and to gather preliminary evidence concerning the budgeting and monitoring system. Here is a transcript of part of that interview.

Auditor: Perhaps you could tell us about any changes you have made to your budgeting and monitoring system since we finished last year's audit?

VP Finance: the fundamentals of our system have not changed and remain as they were last year and the year before that.

Auditor: We are particularly interested this year in how you monitor progress against the budgets.

VP Finance: This part of the system has not changed very much. The key of course is developing a good budget and standards. The budgets are developed by the divisions and challenged here at headquarters. There is often a lot if negotiating back and forth before the final budget are agreed on. We feel that to be effective, budgets have to be aggressive, but achievable.

Controller: Effective monitoring depends on what actions we take on the monthly variance reports. It is our policy to meet during the first 10 working days of each month with the management of each division to discuss their last month's variance report and what they intend to do about it.

Auditor: What is the timetable for this activity?

Controller: The senior managers of each division are expected to meet by the fifth working day after the month end to review the variance report and decide what actions needs to be taken. They prepare a report on their variances form plan which is sent to us here in corporate headquarters. By the tenth working day following the month end, the divisional manager and the divisional controller will have met with the VP operations and one of us to review the variance report, respond to their challenges and discuss their plan for the current month.

(Auditor thins: this is too general - we need to look for specifics)

Auditor: Who at headquarters supports you in this activity?

Controller: We have a good group of corporate accountants at present, who monitor divisional results. Make comparisons against last year's results and this year's budgets and compare results across divisions. They arm us with the questions to ask when we meet with divisional management.

Auditor: What variances do you looks at?

Controller: The threshold depends on the nature of the items - we have a higher threshold for volume variances than we have for cost variances. Our costs accountants will raise questions on variances above these thresholds and will highlight them in the variance reports prepared for the VP Finance and myself.

Auditor: Do you have a written schedule of these thresholds?

VP Finance: No, and for a very good reason: we want our accountants to point out to us anything unusual, even if it is quite small - especially if it is forming a pattern. As a rule of thumb, however, we also work to a threshold of $50,000for monthly figures

(Auditor thinks: Management seems to take variance analysis seriously. We should confirm the thresholds with the cost accountants. Now to verify the applicability of this system to potential errors.

Auditor: We are interested in how this system interacts with your computerised accounting system and whether it helps ensure the accuracy of your accounting records.

Controller: So are we. Each month, the corporate information centre prepares reports on the actual results for the month which include a comparison with the budgets and standards set for the month. The accounting staff at the division investigate variances from their budget, seek explanations from the other managers, examine supporting documentation and prepare a detailed report. Occasionally, this analysis of variances from budgets and standards indicates that the variance is due to an error in the accounting records, such as an expenditure charged to a wrong account or division. In such cases, the division management will ensure that the errors are immediately submitted for correction and appropriate journal entries prepared.

Auditor: What kinds of accounting error have been found by this process?

Controller: Every month there are a number of adjusting journals for misclassified items between division and between classification within a division. The most serious error this year occurred three months ago when on division's daily sales data for the last day of the month was omitted from the monthly computer run.

Auditor: Would you show me later how that error was detected and what reports highlighted us as an error?

Controller: Certainly.

(Auditor thinks: so there seems to be good monitoring and errors are detected.)

The auditors continue the interview and question senior management about how they monitor the operations at the divisions, activities performed at headquarters, the emerging role of internal audit and monthly meetings with divisional management.

REQUIRED

1.Identify four risks faced by Electronic Enterprises Limited with regard to its budgeting and variance analysis system.

2.Identify related mitigating controls for each of the risks identified in 1 above.

3.List the assertions relating to the risks impacted by the identified controls.

4.Design audit procedures to satisfy the assertions identified in 3 above.