You are doing a walk-through of the credit and collections function to get an idea of what internal controls exist and where there might be weaknesses. Then, after you finish, you or another member of the audit team will be testing the system to determine whether the internal controls actually exist and actually work as you have been told. In the meantime, keep your eyes, ears, and mind open for any weaknesses in internal control.

The department head of the credit and collections department is telling you how things work in the department. "Jenny, here, receives the mail and distributes it to the various collectors. They each open their own mail. There is a lot of correspondence going back and forth to and from customers, so it is easier if each collector just handles her own mail." It is easy for Jenny to distribute the mail because most of the letters are addressed to a specific individual.

You watch as one of the individuals opens the mail and handles the items inside. Many of the items are disputes-the customer says the items billed were not ordered, or, if ordered, were not received. Every such letter results in the disputed bill being written off. As the department head explains, the vice president of sales told him, a few years ago, that too many customers were complaining that the credit department was too tough on them, so he had decided that rather than have any more complaints, every such bill would be written off. The procedure is that the collector initiates a form, called a write-off form, to write off a particular amount from a customer's balance. In the explanation block, the collector simply writes "customer dispute." This form is signed by the collector, sent to accounting, and accounting processes the forms each Wednesday. There are so many letters with so many disputes that the department has a monthly competition for the most unusual letters, which are tacked up on a bulletin board. All the rest of the dispute letters are thrown away as soon as the collector has filled out the write-off form.

Collectors also receive checks in the mail. These are payments from customers whose accounts are wholly or partly overdue. As one of the collectors explains, they each receive a print-out once a month, so if the customer sends in a payment, there is no way for the collector to find out about it before the next month's print-out arrives unless the collector receives the payment. Most of the collectors process dozens of payments each month. They make whatever notations they need on the monthly print-out, prepare a deposit ticket, send the department's runner to the bank each Friday (collections are accumulated until Friday, with the customers' payments being held in an otherwise empty desk drawer until then), and send the receipted deposit ticket on to the department which records collections of cash. The credit and collections department also sends a listing of which customers to credit for having paid all or part of their balances.

Near the end of each fiscal quarter, the corporate controller gets a preliminary set of financial statements, and then he tells the department head by telephone how much the department is allowed to write off in bad debts. Thus, the company writes off bad debts only in the third month of each fiscal quarter. "Why does he tell you by telephone?" you ask of the credit and collections manager. "He doesn't want any written record of it," is the reply.

You are interested in how the department decides which customer balances to write off as uncollectible and which to leave on the books. "We write off the oldest ones, up to the amount of what we have been told we can write off," says the credit and collections manager. "That way, our percentage of bad debts always comes out pretty much in line with what we have done before, and the auditors have always been satisfied with it. They had read some academic articles from some people who recommended using time-series analysis to see if the numbers were correct, so they test the accounts receivable account and satisfy themselves that the sales and receivables are real, but they always test the write-offs and bad debts expense simply by using the time-series analysis recommended by the accountants with those fancy doctorates. Go ask the guy who ran the audit last year."

You inspect the process by which customer payments are received the regular way, which is done in a different department. The company has a special Post Office box set up. Twice a day, some one person from maintenance goes to the Post Office to pick up the mail, including the customer payments received at this special Post Office box. It is not always the same person from maintenance who goes to the Post Office; whoever is available when the department head looks around is typically the one who is sent.

When the person returns from the Post Office, he brings a bunch of mail to the cash receipts department, where the mail is opened and customers' checks are paperclipped to the envelopes they came in. One of the goals of the cash receipts department is to get the customer payments deposited promptly, so after all the checks are paper-clipped, someone from the department goes to the bank, fills out a whole bunch of deposit slips, deposits those checks, and comes back to the department with those receipted deposit slips. Then the department members try to figure out which customer paid which amounts. They are helped by the routing number on the checks, but those routing numbers represent banks, not customers, and multiple customers use the same banks. Consequently, they refer to a listing of routing numbers to identify the banks, then to a listing of banks to see which customers use those banks, and then to another copy of the same monthly print-out used in credit and collections to figure out which of the customers who use that bank must have paid that particular amount. If they cannot make a good guess, they call some of the customers to ask if they are the ones who paid the amount. Once they think they know who paid the amount, they generate a journal entry to debit cash and credit the customer's account; the credit to the customer's account is automatically also a credit to accounts receivable. Since they have a copy of the monthly printout of accounts receivable, when a customer's payment is not for the full amount of an invoice, they just go ahead and adjust that customer's account so the full amount of the invoice is taken off the customer's account. They say they are creating a lot of goodwill with customers that way.

a. What internal control weaknesses do you see in this system?

b. What are the potential effects of these weaknesses?

c. What do you recommend instead (that is, if you have such a recommendation)?