Question

1) UMGC Industries capital-asset procurement policy requires the board of directors (BOD) approve any single acquisition over $500,000. If the BOD approves a project, then the treasurer will transfer the funds to the respective plant. Within one year, the internal auditing function is charged with reviewing each acquisition to check the propriety of the purchase and disbursal of funds.

UMGC Industries plant controller prepared the first proposal for a DEK cutting machine. Other plants were told to wait until internal auditing could inspect the documentation associated with the acquisition and evaluate the project’s operating effectiveness and efficiency. The plant’s proposal was the second largest proposal ever submitted in the company’s history and it totaled $1.3 million dollars. The cost of the new machine by itself was listed in the proposal at $1.1 million. Labor and other costs necessary to remove the old machine and install the new machine totaled $200,000.

      The internal auditor assigned to the investigation was Phil Ramone. Phil had been with the company four years performing mostly production operational audits (on existing processes) and internal control payroll audits. Phil’s considerable experience in these areas led him to believe that the procedures associated with this capital-asset audit would be as simple and routine. This was not Phil’s first visit to the plant. In fact, Phil had performed an audit on the plant’s payroll system only a year ago. Phil’s recollection of the experience was not a pleasant one. He had several confrontations with the plant controller, mostly as a result of personality clashes. While all the payroll issues were easily resolved, Phil felt there was still an adversarial relationship between him and the controller and was on guard for any preemptive strikes this time around by the controller.

It was a long drive to the plant so when Phil arrived a little late the day of his audit he was greeted by the controller with a perceived air of indifference and promptly led to a secluded office. The controller calmly explained that he was extremely busy and would answer any questions at the end of the day. Phil merely nodded his head and sat down in front of several tall piles of invoices, which the controller stated was the documentation supporting the purchase, set up, and testing of the new machine. Phil was somewhat surprised, fully expecting to see only a handful of invoices, but did not ask for any explanations. As Phil began looking through the myriad of statements and canceled checks, he soon found one particular invoice near the top of the first pile that indicated the actual price paid for the machine itself was only $850,000.

Phil’s first reaction was to call the CAE of auditing. When he found that the CAE was out for the day and could not be reached, he then decided to call the VP of Operations at corporate headquarters. Phil was critical of the plant controller when describing the seriousness of his suspicions based on this preliminary information. Phil didn’t know that there was a BOD meeting that day and that the news would be passed on to them. The members of the BOD were outraged, screaming over the alleged misuse of the funds and possible fraud.

Phil was unaware that in a private conference call the chairman of the BOD would soon lambast the plant controller. Seconds after the call, the controller walked up to Phil and had only two words to say – “get out.”

Three days later Phil was called in to the CAE’s office. The CAE described how he personally went to the plant the next day after Phil’s visit and performed the capital-asset audit himself. The CAE found that there were a number of reasonable explanations for the differences between the original proposal and the actual expenditure. To begin with, the company that sold the machine would not discount the price until the BOD approved the contract.  Competing bids drove the cost of the machine from $1.1 million to $850,000. However, there were several factors that offset these savings.

Originally, the setup of the new machine was projected to take a week and a half but ended up taking a month. No one really knew how difficult it was going to be to remove the old machine that was embedded in the concrete floor (to minimize vibration). This removal took additional time and outside labor. Also, the new machine was to be put in the same area where the old machine was located. Since the plant could not afford to shut down for any extended length of time, the old machine was moved over the Thanksgiving Day holiday when labor rates were doubled. In addition, while the new machine was being tested, the old machine had to be kept running in its temporary location. During the time that both machines were running, machine operators and supporting personnel (e.g., those loading and unloading the conveyors) worked double shifts in order to test the new machine. This parallel process took longer than expected because the plant engineers were not familiar enough with the new machine to deal with minor problems. Also, special outside consultants were hired for the first two weeks to set up the machine.

Another unexpected cost arose because the new machine put out a greater number of larger pieces of wood requiring required an additional conveyor belt to accept and carry the larger pieces. The savings from the discount was used to purchase this necessary piece of equipment. In sum, all of these additional and unexpected outlays were very expensive and brought the total to just under the original proposed cost of $1.1 million.

The CAE went on to explain to Phil that the reason for the abnormally large number of invoices was an endless stream of trips to the local electrical and hardware stores to buy the necessary parts and supplies to keep the transition from the old to the new machine moving smoothly. As it turned out, the controller of the plant actually did a commendable job in overseeing the project and keeping accurate records of the disbursements. In fact, the controller created a specialized installation guide that will probably save the company hundreds of thousands of dollars when the remaining plants order more of these machines.

Required

1. Comment on Phil’s preparation for and conduct of the audit. What should Phil have done differently?

2. Discuss all the possible violations of the IIA Code of Ethics and/or International Standards for the Professional Practice of Internal Auditing that Phil committed.  

2)  Internal auditing is going to be performing an assurance engagement dealing with controls over production and inventory. Some of the items to be covered in the engagement include:  

• Determine if there is an issue with excess, obsolete or unsaleable inventory
• Determine if there are inventory shortfalls vs. what is shown in the general ledger
• Determine if inventory write-offs have appropriate approval and support
• Determine if there are material issues with the quality of the company’s finished products.  

For each item, select the two best tests in the reading Audit Tests: Types, Advantages & Disadvantages which in your judgment are the most appropriate to gather the required evidence.  Briefly explain why you selected each test.   Briefly describe what evidence you are trying to obtain from each test.  For your response, you can create a chart.  

Answer 1

1) Comment on Phil’s preparation for and conduct of the audit. What should Phil have done differently?

One of the key managment controll activity is the internal audit to ensure the internal business process is carried out in according with the Article of association (AOA). AOA is the document to prescribe the conduct of the internal business.

Phil had been with the company four years performing mostly production operational audits (on existing processes) and internal control payroll audits which were different from conducting capital-asset audit.

Phil should have taken into consideration all the aspects pertaining to procurment, installation of asset since capital-asset audit different from the production/oerational audit, which is regular in nature and few of the exceptions which can be identified during routin course.

Phil should have follwed the rules of conduct whie preparing and during the course of audit. the basis rules of conduct are a) Integrity b) Objectivity c) Confenditiality & d) Competency.

As per the above rules he was less compentent in conducting the Capital asset Audit and should have engaged in those services for which he is exposed to audit. Further he should have kept the confidentiality of information till the audit is complete.

2. Discuss all the possible violations of the IIA Code of Ethics and/or International Standards for the Professional Practice of Internal Auditing that Phil committed

Code of Ethics - a) Integrity b) Objectivity c) Confenditiality & d) Competency.

a) Integrity - Basis for reliance on the judgement of internal auditor lies on their integrity.

b) Objectivity- Profession objective during the course of audit is to gather, evaluate and communicate the information about the capital asset. Phil should have done the balanced assement of all the relevant circumstances. He should have avoided or not influenced by the own interest/imotion while forming the judgement.

c) Confenditiality -  Phil should have valued and kept the information in his ownership and should have disclosed the information in appropriate forum after understanding all the circumstances.

d) Competency - Knowledge, skills, and experience is the key to audit which was lacking in phil in conducting the Capital asset audit.

Overall he should have declined the audit in the begnning since this kind of audit was not common.

2)  Internal auditing is going to be performing an assurance engagement dealing with controls over production and inventory. Some of the items to be covered in the engagement include:  

Determine if there is an issue with excess, obsolete or unsaleable inventory

Ans: Excess - Will eat up the money by way of unnecessary excess investment in inventory. Opportunity loss of interest, increase in storage cost.

obsolete - Outdated, loss of investment.

unsaleable inventory - Huge investment, storage cost and opportunity cost.

Determine if there are inventory shortfalls vs. what is shown in the general ledger

Ans: Theft, pillferage of of inventory if there is shortage in physical stock vs.that in the General ledger.Liquid gaseous item then proper care should be take for proper storage.

Determine if inventory write-offs have appropriate approval and support

Ans: Yes inventory write-offs should have appropriate approval and support to write off the same. Physial assets should be destroyed in proper observation.

Determine if there are material issues with the quality of the company’s finished products

Ans: If there is quality issue then there is improper use of material. which in turn will impact the sales. Market share will fall.

Advantage of internal audit is to bring the anamolies in management view.

Disadvantage: High costs and postmortem of a happening