QUESTION 2: UNDERSTANDING THE INTERNAL CONTROL PROCESS AND ASSESSING CONTROL RISK Fresh Essence employs a perpetual inventory system

As part of interim audit, Berry Koo the audit senior on this job has completed a 'walk-through' of the procedures for the inventory purchases and payments cycle. The following is a summary of the procedures he documented on the audit file:

1. Nathan Singh, the production manager is responsible for initiating orders for ingredients (raw material to be repacked). The re-order points are pre-set in the production management software Flow7. When the re-order points are reached, the system sends an alert to Singh via an email. Singh will then generate a pre-numbered purchase order (PO) using Flow7. He can also adjust the quantities on the purchase order when they are anticipating increases or decreases in sales. The purchase order is then sent to the purchase clerk Ray Kim via email.

2. For inventory orders, Kim normally sends the purchase orders directly to their approved suppliers ie Cypress and other manufacturers. The suppliers will then send Kim a confirmation of items and quantities and an estimated date for the ingredients to be delivered. When the confirmation is received, Kim will log on his computer, finds the relevant PO initiated by Singh and select the suppliers name on the PO and then click on the box sent to suppliers.

3. If a PO cannot be filled by any of the approved suppliers, Kim may look for a new supplier. When he obtains a quote from a new supplier, he passes the quote and the new suppliers information to Amy Cooper, the financial controller for approval. Once approved, the financial controller will add the new supplier into the approved supplier list.

4. FE requires their suppliers to attach a Delivery Note (DN) with inventory they ordered. DN should have a reference to the relevant PO number and shows the quantities and items being delivered. When a delivery arrives at the factory warehouse, the warehouse assistant Gordon Scully will reject the delivery if there is no PO on it or the PO number is invalid. Scully agrees the DN to the relevant PO on the computer to match items and quantities. Once it is confirmed that the ingredient is ordered by them, the delivery driver is allowed to pump the ingredient into the company's storage tank or leave the cartons in the warehouse. Scully initials and dates one copy of the DN and then passes it to Gary Chen the warehouse manager.

5. When Chen receives the DN, he logs on to a computer and update the PO to be received and the computer will ask a pre-numbered duplicated Goods Receiving Report (GRR) to be printed. Chen requests the computer to print the GRR. The computer retrieves a list of the items ordered and supplier details and prints the GRR. Chen then count the actual items against the GRR. For liquid items, Chen reads the measure on the tank to count the litres. Once all items are counted and checked, Chen updates the inventory record to reflect the actual items and quantities have been received. When updating inventory, the computer asks for the relevant PO, if the computer accepts the PO number, it automatically display the ordered items and quantities and ask Chen to either agree to it or amend the items received. After Chen updates inventory, the system will generate a journal (Note: the journal posted by the system is Dr Raw materials inventory; Cr Creditor.) Chen then writes the journal number on the GRR and signs it. The signed GRR together with a copy of DN are left in a tray on the desk of Kim.

6. If discrepancies are found between the DN and the results from the actual counting, a copy of the GRR and DN will be passed to Kim to contact the suppliers. Inventory will not be updated until the discrepancies are sort out.

7. Kim receives all supplier invoices. Suppliers include the relevant PO number on their invoices to FE. On receipt of an invoice, he agrees the details on suppliers invoice against the relevant PO with received status. If there are no discrepancies, he prepares a payment requisition for the invoiced amount and forward the payment requisition, with the invoice attached, to the financial controller for authorisation. For any payment over $30,000, the MD needs to authorise the requisition.

8. The financial controller and/or MD signs the payment requisitions to confirm authorisation and forwards the documentation to the banking clerk who keys the payments into the payment journal (the journal posted by the system is Dr Creditor; Cr Bank). The system generates a journal number which the banking clerk writes on the payment requisition to make sure the account payable balance is updated. She files the payment requisitions with the supporting documents.

9. The banking clerk then loads the payments on the online banking facility with reference to the payment requisition number. Both the financial controller and MD must approve and release the payments. The banking system automatically sends electronic transfer records to the financial controller who subsequently forwards them to Kim. Kim checks it against supplier invoices and then sends a remittance advice to individual suppliers.

REQUIRED

a) Identify control weaknesses for the above system For each weak control:

b) Explain how it contributes to the audit risk exposure

c) What substantive tests would be carried out to reduce audit risks You may use the following format to present your answer.