Financial System Auditing, KMO Internal Control Management, A1 May -2015, Bois de Chauffage

Financial SysteM AuditinG Management control systems of Kalka Mail Order Co.

Audit working papers

Table of Contents Introduction 1 1.1 Purpose and use of the different accounting records

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Purpose of accounting record 2 Accounting cycle 2 1.2 Importance & meaning of applicable fundamental accounting concepts

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Importance of applicable fundamental accounting concepts for KMO

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12 fundamental concepts in accounting (GAAP)

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1.3 Factors influencing the nature & structure of KMO accounting systems

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KMO Co. size, natue & structure

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Key aspect of accounting system

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Manual & computerized system 10 2.1 Components of business risk associated with KMO Co.

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Business risk 12 Components of business risk relating to KMO Co.

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Control business risk 15 2.2 Control systems in place at KMO Co.

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Internal control

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Test of control 20 2.3 Risk of fraud within KMO Co. & suggestion of detection methods

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Fraud & types of fraud 23 Prevention & detection of fraud 24 Fraudulant activities at KMO Co. 25 Conclusion 27 References 28

Financial System Auditing Management Control Systems

Introduction The Kalka Mail Order (KMO) Company is Sunderland (UK) based and operates a central warehouse from which post or carrier to the company’s 8 million customers distributes all merchandise. The company accounting records consist of the process of recording, classifying, summarizing, reporting, analysing and interpreting information of various transactions carried out by the company. Decision makers use all this information in order to make an appropriate and timely decision. Production of financial information through financial statements is based on systematic and routine-based activities. Financial data is based on economic activities of Kalka Mail Order Company, which is recorded according to the accounting requirements. This report will explain the purpose and types of accounting record used by KMO Co. and the importance and meaning of the fundamental accounting concepts applicable in KMO. More than that, this report also evaluates some factors that might influence the nature and structure of accounting systems at the company. It also identifies the different components of business risk associated with the company, analyze the control systems in KMO Co., and define types of fraud the company confronting in business.

Nguyen Dinh Bao

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Financial System Auditing Management Control Systems

Accounting Records in KMO

Accounting records

the purpose & the use in KMO 1.1

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Accounting system in KMO Co.

According to the scenario, KMO has a central warehouse which distributes goods across the country (UK). And their customers are diversified, which include 8 million retailers and individuals. KMO is considered as a big company with a complex accounting system. Hence, the accounting process and data collection in KMO face many difficulties. Moreover, KMO is a merchandizing company, thus their main business activities are distributing goods, stocking and storing products. There are a lot of transactions happening everyday, including the process of recording, classifying, summarizing, reporting, analysing and interpreting information of various transactions. Therefore KMO needs to record various information. Different departments need to record different transactions. Accounting is collecting, processing and providing information about all assets and assets’ rotations of a business in order to offer necessary and useful information to support business decision-making and evaluate business operations. The importance of accounting is providing information on a company’s financial results and its position (BPP Learning Media, 2010). The main functions of accounting in KMO are listed below. • Observing, collecting and recording operations and transactions in an accounting method • Classifying transactions according to issues and groups • Recapitulating classified information to form financial statementss, in to order to satisfy the requirements of users Accounting records are all documents and books that the company needs to prepare financial statements or records. They are records of assets and liabilities, monetary transactions, ledgers, journals, cheques and invoices, delivery notes, purchase orders, agreements, books of accountant (BPP Learning Media, 2010).

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Accounting cycle

Accounting cycle is the collective process of recording and processing the accounting events of a company. The series of steps begin when a transaction occurs and end with its inclusion in the financial statements. This process demonstrates the purpose of financial accounting - to create useful financial information in the form of generalpurpose financial statements.

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Financial System Auditing Management Control Systems

2.1

Accounting Records in KMO

Source documents. The company identifies and analyzes transactions and generates source documents such as cheques, purchase invoices, sales invoices, delivery notes, purchase orders and credit notes (Gill and Consseraat, 1996). For example, this is a sample of KMO credit note. KMO Credit Note



KMO Co. Address in UK

Date of issue

Against: (supplier name)

Goods returned as per delivery

Amount (£)

Description Detail 1 710

2.2



Detail 2

990

Signature of KMO manager

Date

Journals are used to record transactions as a debit and a credit. They record all of the essential information about the transaction such as the date, the accounts involved and a sort explanation (Gill and Consseraat loc cit, 1996). Typical examples are sales day books and purchase day books. KMO General Journal

Date Accounts Debit (£) Credit (£) Work note Apr 01, 2015 Cash 25,000 issue stock to Capital Stock 25,000 shareholder for cash Apr 08, 2015 Advertising Expense 21,500 Cash 21,500 paid for ads program Apr 17, 2015

Account Receivable 31,200 provide services to

Service Revenue 31,200 customer on account Apr 24, 2015 Account Payable 500 paid half of the utility Cash 500 bill received on Jan 2015 Apr 30, 2015 Utilities Expense 4,200 receive bill for utility Account Payable 4,200 cost incurred Nguyen Dinh Bao

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Financial System Auditing Management Control Systems

Accounting Records in KMO

2.3

Ledger (T-accounts) The debit and credit values of journal entries are transferred to ledger

2.4

Trial balance is the list of all the debit and credit balances at a particular date. A trial balance

accounts one by one in such a way that debit amount of a journal entry is transferred to the debit side of the relevant ledger account and the credit amount is transferred to the credit side of the relevant ledger account (Gill and Consseraat loc cit, 1996). There are three types of ledger which are sales ledger, purchases ledger and general ledger.

is calculated to confirm that the sum of the debits is equal to the sum of the credits. Balance sheet or financial statement is important because it shows KMO total profit; and KMO directors, shareholders and other users will examine the financial statement to understand KMO position. A balance sheet includes sssets, liability and owner equity. Together they form the accounting equation. Asset = Equity + Liability

KMO Co. Trial Balance at 19 March, 2015 Assets (£)

Liabilities & Owner Equity (£)

Vehicles 167,000

Partnership capital

Cash sales

167,000

175,000 Cash expense 112,800

Cash from receivables

133,700

Bill payment 144,204

Profit and loss account

51,696

Bank loan

144,204

4,000

Bank loan interest

Pension obligations

4,000

Cash in hand

30,000

Bank overdraft

30,000

Cash requirements

500

Total 510,000 510,000

2.5

Financial statements. Based on the trial balance, balances can be transferred to the income statement and statement of financial position. Therefore, KMO accountants are able to prepare financial statements. They include income statement and balance sheet (Gill and Consseraat loc cit, 1996). Nguyen Dinh Bao

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Financial System Auditing Management Control Systems

Fundamental Accounting Concepts that are Applicable at KMO Co.

Fundamental applicable

accounting concepts 1.2

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Accounting concepts

Accounting concepts are a set of broad conventions which offer a basic framework for financial statements. As financial reporting involves significant professional judgments by accountants, these concepts and principles ensure that the users of financial information are not mislead by the adoption of accounting policies and practices that go against the spirit of the accountancy profession (Gill and Consseraat loc cit, 1996). In another word, accounting concepts are rules that all companies need to comply when they prepare all accounts and financial statements. Accounting concepts are really important for KMO. Firstly, all companies have to prepare financial statements. They need to be prepared and reported honestly and logically. The financial statements are prepared to serve users which are investors, lenders, management, suppliers and trade creditors, government, customers, employees as well as public. The financial statements are true and reasonable, if they comply with the fundamental accounting concepts. When KMO applies the fundamental accounting concepts, it can prevent mistakes and risks in recording, saving and collecting and save time, money and effort. Furthermore, the company is able to forecast its situation.

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Business entity

The income and expenses of the business have to be treated as separate entity from its owners. It means owner’s income and expenses will be different from the company’s income and expenses. The owner and the business are distinct from each other (BPP Learning Media, 2010). Any payment for the owner’s personal expenses by the business will be treated as drawing and reduced the owner’s capital contribution in the business. For example, if Dave Alton is the owner of KMO Co. and Alton spends £200,000 to buy a new car for his personal purpose. This amount is recorded on the books to reduce the equity of owner and not relevant to the expense of operations of the company.

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Financial System Auditing Management Control Systems

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Fundamental Accounting Concepts that are Applicable at KMO Co.

Money measurement

In financial statements, money is used to be a measurement in order to express the value of each items and transactions. Hence, only transactions which can be showed in terms of money are able to be recorded in financial statements. The company cannot record transactions or events which are not showed in terms of money in books of accounts (BPP Learning Media, 2010). For example, a team of dedicated and trusted employees of KMO is an asset of the company but the company cannot disclose them in the accounts in monetary terms. Hence, they are not expressed in the KMO’s books. However, the use of a building or clerical service can be expressed in terms of money so they are able to be recorded in financial statements.

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Going concern

Going concern is an assumption that a business constantly operates. All businesses have to prepare financial statements and users assume that these companies will survive at least twelve months from the date recorded in the financial statements in case of that the companies do not have attention to be liquidation of an enterprise or bankruptcy. Besides, according to going concern, existing liabilities will be paid at maturity (BPP Learning Media, 2010). For example, in a balance sheet, KMO recorded the date of 31 December 2013 which was the end of financial year but in the end of this balance sheet, CEO signed in 15 January 2014. It means the balance sheet ended in 31 December 2013 but the date which KMO prepared the balance sheet is 15 January 2014. Hence, when users read the balance sheet and see the date when KMO prepared the balance sheet was in 15 January 2014, the users would assume that KMO would survive at least twelve months which means it is able to operate until 15 January 2015 at least.

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Prudence/Conservatism

The provision for doubtful debts should be made. If there is only a signal of revenues or profits, it is not recorded in the profits and loss account but if there is a signal of expenses and losses whether the amount is known for certain or just estimation, it has to be recorded in financial statements. This accounting principle helps the company ensure that assets and income are not overstated and liabilities and expenses are not understated in order to prepare provision for unexpected situations (BPP Learning Media, 2010)). For example, in April 2014, a customer order a batch of electrical equipment worth £500,000 and KMO will deliver them to the customer in June 2015. It means KMO cannot record this amount of money in profit and loss statement until June 2015. KMO needs to ensure it will deliver right products to customers and receive money. KMO prevents the situation that the customer can cancel the contract of purchasing. Nguyen Dinh Bao

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Financial System Auditing Management Control Systems

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Fundamental Accounting Concepts that are Applicable at KMO Co.

Materiality

The provision for doubtful debts should be made. If there is only a signal of revenues or profits, it is not recorded in the profits and loss account but if there is a signal of expenses and losses whether the amount is known for certain or just estimation, it has to be recorded in financial statements. This accounting principle helps the company ensure that assets and income are not overstated and liabilities and expenses are not understated in order to prepare provision for unexpected situations (BPP Learning Media, 2010). For example, in April 2014, a customer order a batch of electrical equipment worth £500,000 and KMO will deliver them to the customer in June 2015. It means KMO cannot record this amount of money in profit and loss statement until June 2015. KMO needs to ensure it will deliver right products to customers and receive money. KMO prevents the situation that the customer can cancel the contract of purchasing.

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Consistency

Companies cannot change the accounting methods and treatments in the same accounting period in order to ensure that the users can compare information. They have to choose the most suitable accounting methods and treatments. Besides, without a valid reason, they cannot be allowed to change the accounting method and treatment. Moreover, if they change successfully the accounting method and treatment, they have to show and explain clearly in the financial statements (BPP Learning Media, 2010). For example, the same method to calculate inventory is applied for the same items and the same accounting period. It means if KMO applies FIFO method, it needs to use this method in the same accounting period and if it wants to change from FIFO method to LIFO or Average, it has to ensure that the new method is better and reflect the true and fair view of KMO’s financial position.

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Accruals

Accruals means revenues are recognized when the sales invoice is issued but not when the customer pays (credit sales). Besides, expenses need to be recorded in the accounting period when they are occurred, but not in the following period in which they will be paid (BPP Learning Media, 2010). KMO Co.has to ensure that expenses must match with revenues in an accounting period. For example, KMO purchases an insurance for its building so KMO must pay to the insurance company £600 twice a year (£600 in January and £600 in July). The company needs to recognize £100 expense for each month for the whole year. Therefore, expenses are recorded when they are incurred: £100 for January, £100 for February, £100 for March, £100 for April and so on.

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Financial System Auditing Management Control Systems

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Fundamental Accounting Concepts that are Applicable at KMO Co.

Realization

Realization: affirms that revenues are supposed to be recorded only when realized. It means sales are made only when the goods are transferred to customers or services are rendered (BPP Learning Media, 2010). For example, a customer orders a batch of goods worth £100,000 and he pay a deposit of £30,000 and the remaining £70,000 will be paid when the batch of goods are delivered to the customer. In this situation, the sale is not recorded when the customer order, it is recorded when he receive the batch of goods and pay full money.

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Uniformity

Different companies which are relevant or operate in the same industry are supposed to apply the same accounting procedures, measurement concepts, classifications, and methods of disclosure for similar transactions. Uniformity facilitates to compare their financial positions (BPP Learning Media, 2010) For example, when HMRC wants to check profit and loss accounts of companies working in manufacturing electrical equipment, KMO and other companies in this industry have to apply the same accounting methods. Hence, HMRC can compare among the companies.

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Disclosure

Different companies which are relevant or operate in the same industry are supposed to apply the same accounting procedures, measurement concepts, classifications, and methods of disclosure for similar transactions. Uniformity facilitates to compare their financial positions (BPP Learning Media, 2010). Market conditions, technological changes and the efficiency of management would be disclosed For example, when HMRC wants to check profit and loss accounts of companies working in manufacturing electrical equipment, KMO and other companies in this industry have to apply the same accounting methods. Hence, HMRC can compare among the companies.

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True and fair

The ‘true and fair’ concept has been a part of English law and central to accounting and auditing practice in the UK for many decades. There has been no statutory definition of ‘true and fair’. The most authoritative statements as to the meaning of ‘true and fair’ have been legal opinions written by Lord Hoffmann and Dame Mary Arden in 1983 and 1984 and by Dame Mary Arden in 1993 (‘the Opinions’) (Financial Reporting Council, 2015). Since those Opinions were written, there have been some significant changes in accounting standards and company law which have led some to question whether the views expressed in those Opinions remain applicable. Nguyen Dinh Bao

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Financial System Auditing Management Control Systems

Nature and Structure of Accounting Systems at KMO Co.

Nature & structure of accounting systems at KMO Co.

1.3

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Size, nature and structure of KMO

Size of the company is really big. KMO has various warehouse which locate across the country and its customers are diversified, which include both retailers and individuals. Hence, the accounting process of KMO is absolutely complicated and data collection is really difficult. Moreover, the company also deliver goods through its wide distribution channel. KMO needs to apply a strict system to manage and control accounting activities while operating. Nature of the company. KMO is a merchandizing company with warehouse service so its main activities are purchasing materials, storing, maintaining and delivering goods. Hence, it is clear that problems of KMO are related to inventory, delivery, order and purchasing equipment and credit of customers.

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Authority at KMO Co.

Authority is the right or power to order, decide, command and enforce others or direct and control someone or something. KMO needs an authority system to manage and control activities of the company. Line authority shows that mangers have the right and power to direct and allocate the work and tasks of their subordinates (Gill and Consseraat loc cit, 1996). According to the structure of KMO, the authority system requires that employees of each department need to ask permission of supervisor or manager. Every department has a manager, supervisor and staffs. For example, the accounting manager of KMO can command to accounting staffs to prepare a profit and loss account and a balance sheet in a specific period of time. Staff authority is the right to advise and assist line managers as well as other staff personnel inimplementing their basic goals and objectives. One department is able to offer specialist advice to another department but it has no right to decide (Management Innovations, 2008). For example, when the sales department receives an order from a customer, it has to forward the order to dispatch department so the dispatch department can deliver to the customer and fulfill the sales. Function authority is the mix of line and staff authority. It means a manager can direct, design or control activities or procedures of another department(Financial System and Auditing, 2010). For example, the marketing manager is allocated to conduct the twentieth anniversary of company foundation. Therefore, functional authority is not limited to marketing department. Nguyen Dinh Bao

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Financial System Auditing Management Control Systems

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Nature and Structure of Accounting Systems at KMO Co.

Accounting systems at KMO Co.

Accounting systems play an important role in operations of a company. The company has to keep all books on its credits and debits so there are two accounting systems which are applied in the company in order to complete financial statements. They are manual and computerized systems. The basic differences between two systems are speed, cost and backup. First of all, the key difference of two methods is speed. It is clear that when computerized system processes data and makes reports absolutely faster than manual system. All calculations can be done automatically by software programs which are really efficient and less errors. The users only need to input data and let the software programs do the rest. Moreover, cost is another difference. The computerized system requires a machine and software which are much more expensive than the manual system (the manual system just requires papers and pencils). The company has to offer training and program maintenance when it applies accounting software. In addition, another difference is the backup information. All transactions of the company can be backup easily by the computerized system, which prevent fire or unexpected situations. However, the company cannot save and back up transactions with the manual system because this system records by paper which is really hard to maintain and keep in good condition (Gill and Consseraat loc cit, 1996). Manual Accounting System is that the company keep all records by hard copies. Accountants have to record transactions manually. For example, if customers order goods, inventory is needed to be checked and dispatch department then will deliver goods to customers. It also prepares invoices and delivery notes when it dispatches goods to customers in order to ensure the company provides the right goods to the right customers. If everything is all right, the sales department will keep invoices and record in sale ledger.

Advantages

Disadvantages

The manual accounting system can be easily used in any business It is cheap because the company just needs to use paper and pencil in order to apply this system It is independent on machines The manual accounting system is also more flexible than the computerized accounting system

It is easy to suffer from human errors. It takes longer time to prepare financial reports It is easy to be destroyed by fire, water or time It is not environment friendly

Computerized Accounting System uses computer hardware and software technology to process, give out and distribute information. This system facilitates KMO in recording, storing and analyzing information on financial transactions (BPP Learning Media, 2010).

Nguyen Dinh Bao

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Components of Business Risk associated with KMO Co.

Financial System Auditing Management Control Systems

Business risks

components associatiated with KMO 2.1

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Business risk: brief definition and diagram

Business risks are unexpected factors are able to affect negatively the ability to achieve goals and objectives of a business. They also come from strategies which are not fit to the business. Business risks are considered as the chance that the business’s cash flow is not enough to pay operating expenses (BPP Learning Media, 2010). Clearly, risk participates in most aspects of corporate decision-making, and few can predict with any precision what the future holds for KMO. Risk can take myriad forms - ranging from the specific risks faced by companies, through the current risks faced by particular industry sectors, to more general economic risks (ACCA F2, 2015). Economic risk results from interest rate or currency fluctuations, and the looming risk of recession. And for example of operational risk in KMO, a strike among the truck driver will result in postponement of merchandising distribution. Risk often has negative connotations, in terms of potential loss, but the potential for greater than expected returns also often exists. Obviously, risk is almost always a major variable in real-world corporate decision-making, and managers ignore its vagaries at their peril (Neil, 1986). Accordingly, KMO accountants require an ability to identify the presence of risk and incorporate appropriate adjustments into solutions and decision-making process. And there are three types of risk to be concerned; examples are described below.

Operational risk

Financial risk

Compliance risk

Bid process Cost of capital Non-conformance with laws

Information transfer

Growth capitalization

Third-party liability

Construction damage Property loss Fail to comply with voided contracts The diagram showed in next page will describe a general process of identifying and resolving risks in KMO Co.

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Components of Business Risk associated with KMO Co.

Financial System Auditing Management Control Systems

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Types of business risk and examples at KMO Co.

Operating risks can be suffered within the operations of KMO business activities. For example, there are some new equipment are purchased when the warehousing process is changed. As a result, there are many plant and equipment are surplus. This risk is related to the operations of KMO. Besides, if KMO does not catch the requirements and expectations of the market, it may produce out-of-date warehouse service and cannot be sold. Specifically, internal risks are frauds, override their commission or mistakes; and external risks are natural disasters, terrorism or monetary losses. For example, if KMO website is not integrated into their inventory systems. And when customers order goods, inventory levels are not checked. This error in warehousing system leads to a circumstance in which money is paid, but there is no good delivered. The clients will be unsatisfied with KMO operations. The case can be worse if journalists find out and report on media. Basically, operational risk is harmful for KMO brand reputation and business performance. Financial risks include all risks which occur if payments are made incorrectly or all due receipts are not collected. Financial risks are bad debts, insolvency, unsmooth cash flow, etc. Financial risks are the chances which affect adversely to the ability to make profits of the business. They influence directly to shareholder’s benefits and may lead to bankruptcy (Knechel, Salterio, Ballou, 2007). The solvency is calculated by following current ratio formula. Current assets Current liabilities Current assets Current liabilities Working capital = Current assets Current liabilities

>1

Good current ratio, KMO has ability to meet short-term debt obligations