Make sure you take your time and provide complete answers. Two or three sentence answers to any of these questions will not be adequate! Your logic, thought processes and quality of your responses are what will determine your grade.
1) ABC’s capital-asset procurement policy requires the Board of CAEs (BOD) approve any single acquisition over $150,000. If the board 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.
ABC’s 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 ABC 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 Board were outraged, screaming over the alleged misuse of the funds and possible fraud.
Phil was unaware that in a private conference call the Chair of the Board of CAEs 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.” Phil was flabbergasted; he called back to headquarters, only to receive a rather icy response from the Chair of the BOD’s secretary suggesting that he return immediately.
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 ABC hundreds of thousands of dollars when the remaining plants order more of these machines.
a) Comment on Phil’s preparation for and conduct of the audit. What should Phil have done differently?
b) Discuss and cite the possible violations of the IIA Code of Ethics and/or International Standards for the Professional Practice of Internal Auditing that Phil committed. Be specific.
2) A summary of an internal audit engagement performed at the request of executive management is presented below.
The claims department of XYZ Insurance Company has instituted new claims procedures for local offices. The new procedures have been designed to improve the review of claims and to prevent both overpayment and payment of false claims. Management mentioned concern about the new procedures at the opening conference of the audit engagement. Management told the internal auditors that 30 complaints had been received recently about the excessive time it took to receive the insurance proceeds for their claims. The company advertises 48-hour claim service. Each of the 30 claims that generated the complaints took seven days. Management said these were the first complaints of this type and were received only after the new procedures were implemented. Management feared that if the claims took too long to process, many clients would switch to another company. The internal auditors decided to find out if processing time had really increased, and if so, whether this was because of the new procedures.
The internal auditors decided to test 25 randomly selected claims made since the change in the procedures and 25 claims from before the procedures and compare them. The tests revealed that the new process had caused an increase in the processing time for two reasons. First, there was a learning effect with the new required forms. The headquarters claims department often had to correct the forms and request additional information before claims could be processed. Second, the new process required a more extensive review than before, sometimes even including a field visit by one of the claims staff in addition to the regular inquiry by one of the company’s claims adjusters.
The internal auditors estimated that the delayed disposition of the claims seriously eroded the marketability of the company’s insurance policies, perhaps decreasing sales by as much as 10 percent the first year and up to 25 percent in subsequent years. The new procedure also increased the cost of servicing claims by 5 percent to 10 percent, depending on whether an additional inquiry is conducted by one of the claims department staff members. The estimated savings on payment of improper claims was equivalent to a maximum of 10 percent of total expenditures in any one year.
There were differences of opinion within the audit team as to the appropriate course of action. After much debate within the audit team, the final audit report recommended returning to the previous claims service procedures, with minor modifications, to avoid the problems associated with the revised procedures. The additional review procedure recommended in the report was a computer scan of company records to ascertain any previous claims by the 30 claimants and the nature as well as the amount of prior claims.
A) Write an alternative internal audit recommendation to the one in the final audit report. You should include at least two specific actions in your recommendation.
B) Describe at least three alternative internal audit procedures the audit team might have chosen to those procedures the team actually performed. Why do you consider your procedures to be superior to the ones chosen?
3) The Foundation for Critical Thinking states that all subjects have a fundamental thought process. In order to understand the thought process, they recommend raising some questions. Please respond to the three questions below using what you have learned in this course.
a) What are some of the most basic concepts in internal auditing?
b) What kinds of questions do internal auditors ask?
c) What types of inferences, judgments and assumptions do internal auditors make?
4) a) When and in what ways do audit engagement communications occur?
b) What actions regarding audit engagement observations must the internal audit function take after the
final audit report is issued? Be specific.