EVALUATION OF INTERNAL CONTROL ENVIRONMENT INTRODUCTION Joe Jones is a manager in the CPA rm of Jones, Murphy, & Smith, P. C. He has been given the job of managing the audit of XYZ (30., which provides industrial and domestic carpet steam-cleaning services. XYZ has never been audited. Thus Joe does not have any prior-year working papers to review. Joe recently conducted a preliminary interview with Bill McConnell, who along with his brother, Tim owns XYZ. Joes objective for the interview was to establish an understanding of the control environment. To prepare for his interview, Joe reviewed professional auditing standards. Those auditing standards indicate that the control environment "sets the tone of an organization, inuencing the control consciousness of its people. It is the foundation for all other components of internal control, providing discipline and structure." The standards state the control environment factors include the following: - Integrity and ethical values 0 Commitment to competence - Board of directors or audit committee participation - Management's philosophy and operating style - Organizational structure - Assignment of authority and responsibility - Human resource policies and practices REQUIREMENTS Based on the information provided in the interview that follows, you are to evaluate XYZ's overall control environment. To assist you in making this overall assessment, you will nd detailed descriptions of factors that may weaken or strengthen each of the seven components. After reading the interview dialogue, rate the effect that each of the seven components has on the control environment. When making your judgments, circle the appropriate number according to the scale provided. After evaluating the seven components, make the overall assessment of the control environment. In addition to rating the control environment on the rating sheet, write up a justication for how you rated each of the seven components. INTERVIEW WITH CLIENT Joe: Bill, can you give me a little information on the background of XYZ? Bill: XYZ provides both a domestic and industrial carpet steam-cleaning service and sells a relatively small amount of inventory, such as spot removers and carpet fresheners. Our company provides this service throughout three counties, which cover over 40 townships in a densely populated area. XYZ is completely owned by Tim and me. Joe : Bill: Joe: Bill: Our business has grown steadily over the course of several years after starting out with just one car-pulled trailer over ve years ago. Over the years, the business has gradually added 12 fully equipped vans, worth about $30,000 each. Now in our sixth year of business, we plan to purchase approximately one new van each year to meet the growing demand for our services. The company grossed just over $1,650,000 in revenues last year, about half of which was collected in cash. We feel our continuing success is due in large part to "word of mouth." Can you tell me something about the day-to-day operations? Well, Mr.Day, our ofce manager, and I are in charge of a small sales force that goes out on leads to give estimates for new jobs. Mr. Day is paid a salary plus a percentage of the total sales each month. My brother, Tim, is usually out in the eld managing the 20 employees who work as cleaners for XYZ. Tim also helps with managerial and operating decisions. Salespeople are paid on a commission basis, selling both the domestic and industrial jobs based on standard prices established by the owners. Salespeople may sometimes negotiate special cut rates during the slower spring and fall seasons. Of course, these are almost always subject to approval by me or Mr. Day. Large industrial jobs are typically booked well in advance of the actual work. The job commitments obtained by the salespeople are normally submitted to Mr. Day who signs them to indicate his approval and then returns them to the salespeople. Sales people then forward job commitments to one of two data input clerks for processing. The computer processes each commitment by extending the number of jobs by the standard price stored on the pricing le, or in specially negotiated situations, by the price on the input document. The sales, accounts receivable, and commitment les are updated and invoices are produced. An exception report of special prices is produced and sent to the salespeople to ensure that the specially negotiated commitments to jobs were processed correctly. Mr. Day developed this sales system himself and it's working rather well. He's currently in the process of creating the user manual for the system. I've also noticed that he sometimes makes adjustments to improve the system, which makes the accounting process more efcient. Weve agreed that he'll reevaluate the process at least once every eight weeks. And how about your accounting department? How big is it, and who oversees the accounting process? The accounting department of XYZ consists of seven part-time clerks, including the two data input clerks, who are all paid an hourly wage. All except one are college students working toward their accounting degrees. Mr. Day trains all new accounting help when they are hired. Typically, they stay on with us until they graduate, which usually covers Joe: Bill: Joe: Bill: two full years. We keep them pretty busy around here, but everyone helps each other out and they always get the job done. What are your Brother Tim's responsibilities? Tim manages the service component of the business. He usually trains all newly hired cleaning employees and explains their specic duties and responsibilities. When he feels sure that the employee is ready, the new hire is teamed up with a more experienced worker and assigned to a truck unit. When additional help is needed, Tim places ads in the local newspaper. Tim is the expert at running that end of the business. What about employee turnover? We haven't had a problem with employee turnover. Tim expects some turnover in this type of business and knows how to deal with it. We try to prevent any employee concerns by maintaining an open door policy and encouraging employees who have questions or concerns about their responsibilities to ask for help or to come talk with us. If a problem should arise that might affect others, Tim or I will immediately address the problem at the monthly ofce meeting, making all employees aware of the issue. Both Tim and I work hard to ensure that any problem is resolved promptly. LATER THAT DAY, AFTER SPENDING TIME WITH THE ACCOUNTING STAFF, TED HAS A MOMENT TO ASK MR.DAYA FEW QUESTIONS Joe: Mr. Day I'm wondering if you could help me clarify some things regarding my brief observations of the accounting staff? Mr. Day: Sure, I'd be glad to. What can I do for you? Joe: I got the impression from the staff that they're not always certain about their assigned functions. Are job responsibilities clearly dened? Mr. Day In assigning ofce responsibilities, Bill says the main consideration is that work should be done by the people who are familiar with a task and who are capable of doing it. But, he also admits that availability has to be a consideration. Although this does lead to some overlap in duties, it doesnt create any confusion in responsibilities. I carefully assign the daily duties and overview each day's accounting records. This keeps the office running smoothly and in a well- organized manner. Joe: The staff mentioned that they've occasionally had problems processing collections of trade receivables. Do you prelist cash receipts before they're recorded? Mr. Day: Well we haven't really experienced any need to. The system is set up so that we collect all of the checks at the end of the day, making it possible to record them all at one time. This way, we can be more efcient by avoiding the need to write Joe: Mr. Day: Joe: Joe Bill: Joe: Bill: Joe: Bill; them down twice. On those rare occasions when there is a collection processing problem, we resolve it immediately. Do you ever run into accounting policy problems? Not very often. I usually handle any policy problems that do arise although Bill will handle the situation if he feels strongly about the issue. Well, thank you Mr. Day. I need to talk to Bill before he leaves for the day. A few moments later in Bill's ofce... Are you satised with the processing of trade receivables? Yes, denitely. Mr. Day is meticulous in his clerical operations, which is well systematized. He has excellent control over the trade receivables. In fact, it's been over a year and a half since the bank accepted a list of pledged receivables as security for a loan. From then on, we've had access to a continually renewable loan based on a list that's updated weekly. The loan is relatively small, and the contract allows the bank to access XYZ's checking account in the unlikely even that collection of the loan seems doubtful. Perhaps I should add that although Tim and I have no formal accounting training and we have given Mr. Day full responsibility for the accounting duties, Tim and I are the only people allowed to sign company checks. One of the accounting clerks mentioned that you're thinking about making a change in the accounting system. As a matter of fact, Mr. Day has been looking into using a new accounting software package that should make the bookkeeping process an easier task for the clerks. The package includes a budgeting system that should help control costs and identify those areas that need attention. Although I've always monitored the company's expenses, I didn't previously see the need for a formal budgeting system. If something didn't seem right, Tim or I would bring the problem up at the informal monthly ofce meeting between all the employees and try to resolve the issue. Given our current success, the implementation of a more sophisticated budgeting system seems like a wise investment. I'm also interested in your security measures. How do you protect your accounting records and physical assets? After hours, the ofce door and windows are heavily bolted. Only Tim, Mr. Day and I have keys to open the ofce. Although there haven't been any problems, we're considering locking up the le cabinets where the hard copies of the accounting records Joe; Bill: Joe; Bill: Joe: Bill: Joe: Bill; and data disks are stored at night. I've also been meaning to see about having the computers bolted down to the desks. As for the vans, they're kept in a fenced-in lot behind our ofce. Each driver gets a key to the gate lock so they can let themselves in or out for work. We have to do this because a lot of the commercial cleaning is done after hours, when the ofce is closed. As a precautionary measure, we change the lock regularly. That should about do it for now, until I can get in to do some preliminary audit work. But before I leave, I'd like to ask you a few more general questions. To start with, can you tell me what you feel is responsible for XYZ's recent success? Well, Joe, because XYZ is using the newest steam-cleaning procedure, we provide a much better result than the traditional rotary shampoo method used by our competitors. And our customers can tell. Plus Tim and I understand the business well, we are personable and we pride ourselves in doing good work. Having an audit performed by our rm is a big step. Why did you decide to have an audit now? Have you ever been audited before? Tim and I are condent that XYZ is a truly viable concern. We feel that audited nancial statements will corroborate our claim. We're eager to learn what suggestions your firm can give us regarding the most professional way to record and present our nancial statements. We also have an interest in learning how to increase the company's credibility with the local business and banking community. Both Tim and I are excited about the success of our company and we're motivated to continue strengthening the organization with the eventual goal of pursuing additional business opportunities. Weve never been audited before. Although we have used a local tax preparer to ll out our tax returns ever since XYZ has been in business. We did ask another rm, about two years ago, to come in to do an audit. We decided not to have the audit performed, though, because the company's fees were too high. Tim and I decided that XYZ would have to wait for an audit until we could reasonably afford the fees. We've come to the decision that now is the time. Are there any issues of concern that you have regarding the audit? Not really. I'm proud of XYZ. The company has had no record of serious problems and has rarely had a problem with bad debts, since most of our receivables balances are collected within two to three weeks. I understand that XYZ does not have an audit committee, which is typical of an organization this size. Can you tell me if XYZ has a board of directors and if so who serves on the board and how active the board is in overseeing important issues at XYZ? We do have a board of directors. It is somewhat informal, but Tim and I and our wives inction as directors. We do have at least one regularly scheduled meeting each year and we have met on other occasions as necessary. Obviously, Tim and I have pretty good idea of what is happening at XYZ on a daily basis. We do not believe our company is yet at a stage that could effectively support a separate board comprised of outside directors. Maybe we'll do that in a couple of years, if we keep growing. Joe: One nal thing I'd like to ask have you and your brother Tim set out any goals for the future? Bill: Tim and I have spent a lot of time talking about our goals and objectives, but we've never formally recorded them anywhere. Our long term goals are fairly uncertain, but we're hoping to build our nest egg to the point where we can potentially retire early. We both agree that our future plans include expanding our sales territory, increasing advertising, investing more help and additional equipment, and I have to admit, taking a well-deserved vacation to Hawaii. CONTROL ENVIRONIVIENT EVALUATION FORM 1. Integrity & ethical values Weak Weak to Moderate Moderate to Strong Moderate Strong 2. Commitment to competence W Weak Weak to Moderate Moderate to Strong Moderate Strong 3. Board of Directors/Audit Committee participation Weak Weak to Moderate Moderate to Strong Moderate Strong 4. Management Philosophy & Operating Style W Weak Weak to Moderate Moderate to Strong Moderate Strong 5. Organizational Structure Weak Weak to Moderate Moderate to Strong Moderate Strong 6. Assignment of authority & responsibility Weak Weak to Moderate Moderate to Strong Moderate Strong 7. Human resource policy & practices M Weak Weak to Moderate Moderate to Strong Moderate Strong OVERALL EVALUATION Weak Weak to Moderate Moderate to Strong Moderate Strong ...

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