Simon Blank Construction Company has two divisions. The president (Chris Simon) manages the roofing division. Simon delegated authority and responsibility for management of the modular manufacturing division to John Gault. The company has a competent accounting staff and a full-time internal auditor. Unlike Simon's procedures, however, Gault and his secretary handle all bids for manufacturing jobs, purchase all materials without competitive bids, control the physical inventory of materials, contract for shipping by truck, supervise the construction activity, bill the customer when the job is finished, approve all bid changes, and collect the payment from the customer. With Simon's tacit approval, Gault has asked the internal auditor not to interfere with his busy schedule.

Required:

Discuss this situation in terms of internal control and identify frauds that could occur.

instructor's answer (pls dontcopy, use as reference)

1.Material weakness:The facts seem to suggest "a condition in which specific control features [few or none are described] or the degree of compliance with them do not reduce to a relatively low level the risk that errors or frauds in amounts that could be material to the financial statements may occur and not be detected within a timely period by employees in the normal course of performing their assigned functions." Gault has authority and influence over too many interrelated activities. Nothing he does seems to be subject to review or supervision. He even is able to exclude the internal auditor.

An identification of the potential frauds will illustrate the misdeeds he can perpetrate almost single handedly.

2. Almost every desirable characteristic of good internal control has been circumvented:

1. Separation of functional responsibilities:Gault has authorization and custodial responsibilities.
2. Authorization and supervision:Gault is apparently subject to no supervision or review. The accounting staff is probably powerless to challenge transactions because of Simon's apparent approval of Gault's powers. The internal auditor should be independent within the company but not be in a position in which an employee can ask not to be audited.
3. Controlled access:The whole situation gives Gault access to necessary papers, records, and assets to carry out his one-man show.
4. Periodic comparison:No one else apparently has any access to the materials inventory in order to conduct an actual count for comparison to the book value (recorded accountability) of the inventory.

3. Potential frauds Gault could perpetrate include:

1. Colluding with customers to rig low bids and taking kickbacks, thereby depriving the company of legitimate revenue.
2. Directing purchases to favored suppliers, paying unnecessarily high prices, and taking kickbacks as well as even setting up a controlled dummy company to sell overpriced materials to the company. No competitive bidding control allows these fraudulent activities to possibly occur.
3. Through the control of physical inventory, (i) removing materials for himself and (ii) manipulating the inventory accounts to conceal shortages.
4. Ordering truck shippers to provide services for his own purposes and causing the charges to be paid by the company.
5. Manipulating the customer billing (similar to a.) to deprive the company of legitimate revenue while taking an unauthorized commission or kickback.