Exercise 3

Recently, while eating lunch with your family at a local cafeteria, you observe a practice that is
somewhat unusual. As you reach the end of the cafeteria line, an adding machine operator asks how
many persons are in your party. He then totals the food purchase on the trays for all of your family and
writes the number of persons included in the group on the adding machine tape. He hands you the tape
and asks you to pay when you finish eating. Near the end of the meal, you decide you want a piece of
pie and coffee so you return to the line, select your food, and again go through the line. The adding
machine operator goes through the same procedures, but this time he staples the second tape to the
original and returns it to you.

When you leave the cafeteria, you hand the stapled adding machine tapes to the cash register operator,
who totals the two tapes, takes your money, and puts the tapes on a spindle.

Required:

a. What internal controls has the cafeteria instituted for its operations?

b. How can the manager of the cafeteria evaluate the effectiveness of controls? c. How do these
controls differ from those used by most cafeterias?

d. What are the costs and benefits of the cafeteria's system?

Exercise 4

The following are partial descriptions of internal controls for companies engaged in the manufacturing
business:

1. When Mr. Clark orders materials for his machine-rebuilding plant, he sends a duplicate purchase
order to the receiving department. During the delivery of materials, Mr. Smith, the receiving clerk,
records the receipt. of shipment on this purchase order. After recording, Mr. Smith sends the purchase
order to the accounting department, where it is used to record materials purchased and accounts
payable. The materials are transported to the storage area by forklifts. The additional purchased
quantities are recorded on storage records.

Overview of Internal Control

2. Every day, hundreds of employees clock in using time cards at Generous Motors Corporation. The
timekeepers collect these cards once a week and deliver them to the computer department. There, the
data on these time cards are entered into the computer. The information entered into the computer is
used in the preparation of the labor cost distribution records, the payroll journal, and the payroll checks.
The treasurer Mrs. Wan, compares the payroll journal with the payroll checks, signs the checks, and
returns them to Mr. Santos, the superior of the computer department. The payroll checks are
distributed to the employees by Mr. Santos.

3. The smallest branch of Super Fresh Cosmetics in Iloilo City employs Mary Santos, the branch manager,
and her sales assistant, Jane Reyes. The branch uses as bank account in Iloilo City to pay expenses. The
account is kept in the name of "Super Fresh Cosmetics Special - Account". To pay expenses, checks must
be signed by Mary Santos or by the treasurer of Super Fresh Cosmetics, Juan Dy. Mary receives the
cancelled checks and bank statements. She reconciles the branch account herself and files cancelled
checks and bank statements in her records. She also periodically prepares reports of cash disbursements
and sends them to the home office.

Required:

a. List the weaknesses in internal control for each of the above. To

identify the weaknesses. b. For each weakness, state the type(s) of misstatement(s) that is (are) likely to
result. Be as specific as possible.

c. How would you improve internal controls for each of the three companies?

Exercises

Exercise 1

The fraud triangle asserts that the following three factors must exist for a person to commit fraud:
A. Opportunity

B. Pressure

C. Rationalization

Identify the fraud risk factor (A, B or C) in each of the following situations:

1. The business has no cameras or security devices at its warehouse.

2. Managers are expected to grow business or be fired. 3. A worker sees other employees regularly take
inventory for personal use.

4. No one matches the cash in the register to receipts when shifts end. 5. Officers are expected to show
rising income or risk dismissal.

6. A worker feels that fellow employees are not honest.

Exercise 2

Each of the following scenarios is based on facts in an actual fraud. Categorize each scenario as primarily
indicating (1) an incentive to commit fraud, (2) an opportunity to commit fraud, or (3) a rationalization
for committing fraud. Also state your reasoning for each scenario.

a. There was intense pressure to keep the corporation's stock from declining further. This pressure came
from investors, analysts, and the CEO, whose financial well-being was significantly dependent on the
corporation's stock price.
b. A group of top-level management was compensated (mostly in the form of stock-options) well in
excess of what would be considered normal for their positions in this industry.

c. Top management of the company closely guards internal financial information, to the extent that
even some employees on a "need-to- know basis" are denied full access.

d. Managing specific financial ratios is very important to the company, and both management and
analysts are keenly observant of variability in key ratios. Key ratios for the company changed very little
even though the ratios for the overall industry were quite volatile during the time period.

e. In an effort to reduce certain accrued expenses to meet budget targets, the CEO directs the general
accounting department to reallocate a division's expenses by a significant amount. The general
accounting department refuses to acquiesce to the request, but the journal entry is made through the
corporate office. An accountant in the general accounting department is uncomfortable with the journal
entries required to reallocate divisional expenses. He brings his concerns to the CFO, who assures him
that everything will be fine and that the entries are necessary. The accountant considers resigning, but
he does not have another job lined up and is worried about supporting his family. Therefore, he never
voices his concerns to either the internal or external auditors.

f. Accounting records were either nonexistent or in a state of such disorganization that significant effort
was required to locate or compile them.

Exercise 3

A competent auditor has done a conscientious job of conducting an audit, but because of a clever fraud
by management, a material fraud is included in the financial statements. The fraud, which is an
overstatement of inventory, took place over several years, and it covered up the fact that the company's
financial position was rapidly declining. The fraud was accidentally discovered in the latest audit by an
unusually capable audit senior, and the SEC was immediately informed. Subsequent investigation
indicated that the company was actually near bankruptcy, and the value of the stock dropped from P260
per share to P10 in less than 1 month. Among the losing stockholders were pension funds, university
endowment funds, retired couples, and widows. The individuals responsible for perpetrating the fraud
were also bankrupt.
After making an extensive investigation of the audit performance in previous years, the SEC was satisfied
that the auditor had done a high-quality audit and had followed generally accepted auditing standards in
every respect. The commission concluded that it would be unreasonable to expect to uncover this type
of fraud.

Required:

State your opinion as to who should bear the loss of the fraudulent financial reporting. Include in your
discussion a list of potential bearers of the loss, and state why you believe they should or should not
bear the loss.

Multiple Choice Questions

1. What is the primary difference between fraud and errors in financial

statement reporting? a. The materiality of the misstatement

b. The intent to deceive

c. The level of management involved

d. The type of transaction effected

2. Which of the following best represents fraudulent financial reporting?

a. The transfer agent issues 40,000 shares of the company's stock to a friend without authorization by
the board of directors.
b. The controller of the company inappropriately records January sales

in December so that year-end results will meet analysts' expectations.

c. The in-house attorney received payments from a Japanese businessman for negotiating the
development of a new plant in Batangas City.

d. The accounts receivable clerk covers up the theft of cash receipts by

writing off older receivables without authorization.

3. Which of the following creates an opportunity for fraud to be committed

in an organization? a. Management demands financial success.

b. Poor internal control.

c. Commitments tied to debt covenants.

d. Management is aggressive in its application of accounting rules.

Fraud and Error

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4. Which of the following is a common rationalization for fraudulent financial reporting? a. This is one-
time transaction and it will allow the company to get

through the current financial crisis, but we'll never do it again. b. We are only borrowing the money; we
will pay it back next year. c. Executives at other companies are getting paid more than we are, so we
deserve the money.

d. The accounting rules don't make sense for our company, and they make our financial results look
weaker than is necessary, so we have a good reason to record revenue using a non IFRS method.

e. A. and D.