Session 7 Homework Questions 1) Briefly describe how each of the following factors might affect the strength of an auditee's control environment: a) Perceived value of controls by management b) Clearly defined lines of authority c) Formal policies and procedures d) Adequate personnel with proper incentives e) Documentation f) Adequacy of control procedures and control monitoring 2) Read the following description of the Preview Company. a) Use the following table to assess the strengths and weaknesses of Preview's entity-level controls. I have only included space for three strengths and three weaknesses to limit the length of the assignment. For each weakness you identify, suggest an improvement that would reduce that weakness. Preview Company Case Description Preview Company, a diversified manufacturer, has five divisions that operate throughout the United States and Mexico. Preview has historically allowed its divisions to operate autonomously. Corporate intervention occurred only when planned results were not obtained. Corporate management has high integrity, but the board of directors and audit committee are not very active. Preview has a policy of hiring competent people. The company has a code of conduct, but there is little monitoring of compliance by employees. Management is fairly conservative in terms of accounting principles and practices, but employee compensation packages depend highly on performance. Preview Company does not have an internal audit department, and it relies on its external auditor to review the controls in each division. Chip Harris is the general manager of the Fabricator Division. The Fabricator Division produces a variety of standardized parts for small appliances. Harris has been the general manager for the last seven years, and each year he has been able to improve the profitability of the division. He is compensated based largely on the division's profitability. Much of the improvement in profitability has come through aggressive cost cutting, including a substantial reduction in control activities over inventory. During the last year, a new competitor has entered Fabricator's markets and has offered substantial price reductions in order to grab market share. Harris has responded to the competitor's actions by matching the price cuts in the hope of maintaining market share. Harris is very concerned because he cannot see any other areas where costs can be reduced so that the division's growth and profitability can be maintained. If profitability is not maintained, his salary and bonus will be reduced. Harris has decided that one way to make the division more profitable is to manipulate inventory because it represents a large amount of the division's balance sheet. He also knows that controls over inventory are weak. He views this inventory manipulation as a short-run solution to the profit decline due to the competitor's price-cutting. Harris is certain that once the competitor stops cutting prices or goes bankrupt, the misstatements in inventory can be corrected with little impact on the bottom line. Entity Level Controls Strength Reason it is a strength Entity Level Controls Weakness Reason it is a weakness and suggested improvement b) What factors in Preview Company's control environment led to and facilitated Harris' manipulation of inventory? Your answer here may include items you listed above, but you should relate the specifically to the inventory manipulation in the question. The following two questions refer to the auditor's report on internal controls discussed in chapter 5. 3) What are some reasons that an auditor might modify the opinion paragraph based on control deficiencies? 4) What are some reasons that an auditor might modify the opinion paragraph based on scope limitations