Internal Control Weaknesses in Expenditure Cycle of Adam & Co

This report analyzes the expenditure cycle of Adam & Co and identifies the internal control weaknesses in each of the three expenditure systems and the risk associated with those weaknesses. The report starts with a review of the literature stating the important internal control techniques and benefits of conducting audits. The report also includes system flowcharts of purchases, cash disbursement, and payroll systems. The internal control weaknesses in each system are discussed in detail. The subject is HA2042 and the document type is a case study.

HA2042
Case Study – Adam & Co
Student name
Student Id

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TABLE OF CONTENTS
TOPIC PAGE NUMBER
Executive summary 2
Introduction 2-3
System flowchart of purchases system 2
Internal control weaknesses in the Purchase
system
4-5
System flowchart of cash disbursement system 6
Internal control weaknesses in the cash
disbursement system
7
System flowchart of payroll system 8
Internal control weaknesses in the payroll
system
9
Conclusion 10
References 11

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EXECUTIVE SUMMARY
A Perth-based wholesaler of industrial supplies, Adam & Co, outsources its inventories from the
manufacturers in countries such as China, Thailand and Vietnam. Being a business Analyst, I
have been given the task of analyzing the expenditure cycle of the company. The company’s
expenses are operated using a centralized accounting system software with the networking
terminals at different locations. Purchasing clerk, receivable clerk and accounts payable clerk are
included in the purchase system of the company for deliberately keeping an eye on the overall
process, that is, from checking the inventory to updating accounts and ledgers, preparing
company reports and sending it to cash disbursement department where the clerk would be held
responsible for keeping checks and updating systems. The whole payroll process in accounts
payable department and the payroll department are operated under the surveillance of the clerks.
A close observance of the weaknesses in the internal control of the expenditure systems
determines the risks associated, which generally includes financial losses, debt accumulation,
reputation loss etc. which are normally incidental to a business.
INTRODUCTION
The expenditure at Adam & Co, is carried along using a centralized accounting system with
networking terminal software at different locations. There are specific systems installed with
respect to purchase, cash disbursement and payroll functions which are followed as per the
company policies and regulations. On keeping a close track of the processes, it is observed that
all the three exhibited expenditure processes primarily including internal control weaknesses
needs to be removed by conducting regular and random audits.
The report starts with a review of the literature stating the important internal control techniques
and benefits of conducting audits. This report also lays down to identify the internal control
weaknesses in each of the three expenditure systems and the risk associated with those
weaknesses.
Zhang, Zhou and Zhou (2007) defined internal control as “a process, effected by an
entity's board of directors, management and other personnel, designed to provide
reasonable assurance regarding the achievement of objectives”.
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The large private companies in Australia, are forced to conduct the audits (Carey, Simnett and
Tanewski, 2000) On the contrary, the research has shown that carrying out the voluntary audits
is beneficial to the organisation.
In the assurance of the corporate accountability, auditing forepays primarily giving the accurate
financial report (Carcello and Neal, 2000) and an important governance mechanism (Zhang et
al., 2007).
Blackwell et al. (2008) had laid in their study that 37% of the private firms independantly
audited in the US. Lower interest rates are paid by these firms significantly on rotating the bank
loans than the unaudited firms. Minnis (2011) reported that auditing lowers down the
asymmetry in information by improving the ability of the expected net income for future cash
flows, thereby reducing the firm’s cost of debt with audited financial statements in opposition to
the unaudited financial statements.
At last, the audits of the private company are economically fruitful by giving the lower interest
rates on debt, thereby increasing the credit ratings and always trying to have better access to
credit (Lennox and Pittman, 2011).
SYSTEM FLOWCHART OF PURCHASES SYSTEM
Internal control weaknesses in the Purchase system
The system is lacking of certain controls and weaknesses which are given as below:
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Purchases
Inventory
check
XYZ
Product
required
Vendor Received Warehous
e
Accounts
Payable
Vendor
selection
Digital
purchase
order
(PO)
created2 hard
copies
printed
PO1 PO2
Selected
vendor
File Invoice
I
Packing
slip
Reconcile
and
preparati
on of two
hard
copies of
Receiving
Reports
(RR1
&RR2)
RR1 RR2
RR2 +
goods
Update
inventory
RR filed
temporari
ly
PO
Reconcil
e
PO RR
Invoice
Cash
disburseme
nt
Update
accounts
PO RR
Invoice

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● That there is evident scarcity of the purchase approving authority, which might result in
the expenditure to follow on the unwanted purchase materials, maybe even for the clerk’s
personal usage. There can be theft in the company, both financially and inventorily, due
to this lack of the improper and avoidable expenditures Clearly evident from the
instances of the case study, there is no proper authorized check on the purchases in the
company, which when associated combined with a complete lack of approving authority,
is considered to be an authentic taboo providing a lot more power to the accounts
receivable clerk who can misuse it to order products for personal use or carry out theft in
the name of product purchasing.
● There is no surveillance on the vendors providing competitive prices, better quality
and/or shorter delivery time in the market to compare from the ones associated with the
company. The company might be following the partial laws in which the clerk receives
favors, gifts and/or kickbacks from the supplier for continuous orders. Lot of activities
are maintained under the supervision of many clerks who are illegally taking out the
office goods for use. Various accounts payable clerks controls the selection of vendors,
placement of orders, updating the bills’ file, updating accounts payable subsidiary ledger,
the accounts payable control account and the inventory control account in the general
ledger and many more such services. There is a policy for the receiving clerks to inspect
the goods, match the items against the information in the digital purchase order and the
packing slip, prepares receiving reports, and updates the inventory subsidiary ledger. One
copy of receiving report is received by the accounts payable clerk who filed the report in
the department. All these duties assigned to the accounts payable clerk allows lot of
fraudulent practices to take place each time. For example, receiving and approving the
poor quality products or maybe accepting the products falling short than the numbers
ordered, from the vendors wherein the deal is settled for certain favours or gifts from the
vendors which is kept hidden from the company. This is the reason why duties should be
segregated and reviewed by some other trustworthy person.
An unsupervised purchase system cost heavily to J.M. Smucker Company when one of their
employees. Mark R. Kershey was the chief airplane mechanic in the company who had
submitted false invoices in the name of a fictitious entity called Aircraft Parts Services, Co. to
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Smucker from a period of October 1997 to January 2013. His fraudulent activities cost the
company upwards of $4.1 million (Lumenlearning, 2014).
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SYSTEM FLOWCHART OF CASH DISBURSEMENTS SYSTEM
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Accounts
Receivable
Cash
PO
Cash
Disbursement
Treasurer Vendor
RR
Invoice
Filed till
clearance date
Due date
Prepare cheque Sign
Copy Cheque
Update
accounts
PO
RR
Invoice
Copy
Close
file

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Internal control weaknesses in the cash disbursement system
The difficulties arising out in the cash disbursement system are as detailed below:
● That the documents received from the accounts payable department are not properly
signed and double checked because of which there is generally no accountability of the
actions relating to the cash disbursement. This non-accountability causes serious issues
for the company in the near future since there is no track record found when the
documents are audited at any later date.
● The another problem which creates a nuisance later is that the cheques, prepared by the
cask clerks are not reviewed twice in order to make sure if its correct. In addition, the
treasurer of the company is also receives the cheque duly prepared by the cash clerk
without its supporting documents for keeping track of the transaction when reviewed at
any later date. This ignorance creates chances for forgery or misleading transactions in
the company as there is a wide scope of the clerks, filling in the incorrect information in
the cheque, which could be either intentional or a mistake. Suppose, if the clerk has
erroneously filled in the amount which is less than the actual payable amount, then there
are high chances of deteriorating the vendor-company relationships, and if vice-versa is
done, that is higher is amount is written, then the company would be at a financial loss
only.
The cash disbursement clerk is assigned with a wide range of tasks starting from preparing the
cheque, updating the books of the cheque paid or received register, accounts payable subsidiary
ledger, and the accounts payable control account along with filing invoice, purchase order copy,
receiving report, and cheque copy in the department. This huge responsibilities on signle
employee are always associated with high probability of errors like, he /she may forget to update
the accounts, or may update them incorrectly maybe intentionally or unintentionally, which can
make the financial records appear wrong, confusing and incorrect. Also, there is no review of the
activities of the cash disbursement clerk giving him/her an opportunity to carry out fraudulent
activities.
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SYSTEM FLOWCHART OF PAYROLL SYSTEM
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Copy
Supervisors
PR2
Payroll
department
Accounts
Payable
General Ledger
Disbursement
voucher
PR2
Prepare
paychecks and
update records
Voucher
Pay cheques Cheque for
Imprest
account
PR1 PR2
Payroll register (2
copies)
Time cards
Review
Pay cheques
Review and
distribution
File
Time cards
Time cards PR2
Voucher
File
Time cards
PR1
File

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Internal control weaknesses in the Payroll system
In the company system, there is also an incorporation of the system which has a manuaa card
system for maintaining the working hours of the employees each day which are then reviewed by
the supervisor and the payroll department at the end of the week in order to make sure the
employee has successfully completed the prescribed weekly hours of mandatory working, by the
company. The problem with manual system lies that the employees start to tamper the timings by
creating proxy attendance, also known as buddy punching. Even under the scrutiny of the
supervisor, the risk of error in manual timecard system is high leading to over-paying employees,
which can negatively impact on the liquidity of the company and can also lead to an increment in
the tax burdens.
The payroll clerk has been burdened wide range of work load starting from the maintenance of
the timecard data into the central payroll computer system, printing hard copies of the pay
checks, printing two copies of the payroll register, posting to digital employee records and filing
the time cards, sending the cheques to the supervisors and the payroll register in the payroll
department. Insufficient segregation of duties along with inadequate oversight leads to fraudulent
activities like paying employees who have been terminated or who do not exist in the first place
(also called phantom employees) leading to financial loss, legal repercussions like jail time and
loss of company reputation. A similar case took place in San Bernardino County where four
employees of a California hospital committed payroll fraud in which they allegedly paid
themselves for hours they did not work. One of these employees was former payroll clerk at the
hospital. The amount of money stolen was $800,000, between August 2007 and March 2011.
The audit conducted by the California State Controller's Office cited poor payroll practices at the
hospital as the reason for the fraud (Stewart, 2014).
Another internal control weakness is the absence of payroll preview in which the data is
processed to check its accuracy regarding current employees, number of hours worked, vacation
hours etc. This step is to be done by department separate than the payroll or accounts payable so
that the whole process is scrutinized. Lack of payroll preview is an invitation to embezzlement
where a large amount of money is stolen over a period of time.
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CONCLUSION
A concrete view of the expenses and the entire expenditure system of the company, can lead to
the recognition of a number of internal control weaknesses which if not considered then and
there might cause serious financial and reputational and goodwill losses to the company.
Auditing in the company is immediately required for balancing the internal weaknesses and also
identifying the total losses suffered which may have been incurred due to the fraudulent practices
being carried out in the company.
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References
1. Blackwell, D.W., Noland, T.R., and Winters, D.B., 2008. The value of auditor assurance:
evidence from loan pricing. Journal of Accounting Research, 36 (1), 57–70.
2. Carey, P., Simnett, R. and Tanewski, G., 2000. Voluntary demand for internal and
external auditing by family businesses. Auditing: a journal of practice & theory, 19(s-1),
pp.37-51.
3. Carcello, J.V. and Neal, T.L., 2000. Audit committee composition and auditor reporting.
The Accounting Review, 75(4), pp.453-467.
4. Lennox, C.S. and Pittman, J.A., 2011. Voluntary audits versus mandatory audits.
Accounting Review, 86 (5), 1655–1678.
5. Lumenlearning (2014). Internal Control Issues and Procedures for Inventory | Financial
Accounting. Available at:
https://courses.lumenlearning.com/suny-finaccounting/chapter/internal-control-issues-
and-procedures-for-inventory/ [Accessed 30 August 2019]
6. Minnis, M. 2011. The value of financial statement verification in debt financing:
evidence from private U.S. firms. Journal of Accounting Research, 49 (2), 457–506.
7. Stewart, A. (2014). Unhealthy Payroll Practices. Internalauditor. Available at:
https://iaonline.theiia.org/unhealthy-payroll-practices [Accessed 29 August 2019]
8. Ucsd.edu. (2017). Internal Controls. Available at:
https://blink.ucsd.edu/finance/accountability/controls/index.html [Accessed 29 August
2019].
9. Zhang, Y., Zhou, J. and Zhou, N., 2007. Audit committee quality, auditor independence,
and internal control weaknesses. Journal of accounting and public policy, 26(3), pp.300-
327.
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