Internal Control Report for EarthWear Clothiers – Year Ended December 31, 2016
The Committee of Sponsoring Organizations’ (COSO) identified five components in its internal control framework. The framework allows companies (and their auditors) to thoroughly assess the internal controls in place and identify areas for improvement. The five components are broken down into 17 principles, which are supported by specific points (McNally, J. 2013). Public Company Accounting Oversight Board (PCAOB, 2010) requires auditors to gain an understanding of each component of internal control over financial reporting. As a part of our review we evaluated the five components of internal control in place at EarthWear Clothiers and identified the gaps in internal controls. We determined the level of control deficiency for each and developed recommendations to address the deficiencies.
Control Environment: Earth Wear has a strong control environment in place. The Board of Directors meets quarterly to review the Company’s performance, and all minutes are documented within one week. The Board includes an Audit Committee who meet with both us and the Internal auditors each quarter. The company is conservative in its accounting policies and is committed to preventing and detecting misstatements due to fraud or error. The organizational structure has clear lines of authority among the operating departments. The Accounting Department is well trained, and employees have significant experience as well as high integrity; there has been little turnover in the past 3 years. The Human Resources Department maintains policies for all aspects of personnel (Messier, W., Glover, S., & Prawitt, D., 2017c).
Earth Wear did not effectively plan and prepare for transition of leadership (to demonstrate a commitment to attract, develop, and retain competent individuals in alignment with objectives). Although Earth Wear has a strong Board of Directors and has not had any turnover in senior executive positions, the company was without a Controller for most of the year. The previous Controller unexpectedly left the company in February 2016 to take a job with a competitor. The new Controller was not selected until November 2016 (Messier, W., Glover, S., Douglas, F. 2017a). As a result, control activities that should have been performed by the Controller may not have been performed during the year, increasing the risk of undetected misstatements. I determined that this was a control deficiency, as the likelihood of a material misstatement resulting from this deficiency would reasonably be expected to be remote. I recommend that Earth Wear develop and implement leadership succession procedures that include cross-training staff to allow for interim assignments to leadership positions when necessary. In addition, I recommend adding a written policy regarding this implementation.
Risk Assessment: Earth Wear has established goals related to the company’s products, responsibilities, and growth plans and uses its business plan as well as its budgeting process to monitor decisions. Monthly meetings are held by senior management to discuss recent events and how they may affect the company. There is a Strategic Risk Management Department that is responsible for considering how future events may affect the company, and management relies heavily on this department to identify risks that may affect the company and to recommend appropriate actions (Messier, W. et.al, 2017d). I did not note any gaps in internal controls related to risk assessment.
Control Activities: Earth Wear has a diverse control activities process. There is a budgeting process that includes monitoring activities, and all significant budget variances are reported monthly to the Controller’s office (Messier, W. et.al., 2017b). Proper segregation of duties has been established in all departments (Willis & Adams, 2017a). A new integrated central accounting system was implemented in 2012. (Messier, W. et.al. 2017a). The IT department maintains both strong controls over program changes and detailed documentation on all information systems (Messier, W. et.al. 2017c). Management has created policies and procedures to cover all transactions and processes.
Although they have these activities in place; they did not effectively deploy control activities to ensure that intercompany transfers were properly reconciled. Earth Wear has a significant number of intercompany transactions monthly for transfers of inventory between warehouses and the allocation of marketing costs between the business units. The intercompany transactions are frequently material. There is a formal management policy that requires monthly reconciliation of the intercompany accounts; however, there is no process to ensure that the procedures are performed consistently. As a result, Earth Wear experienced a lack of timely reconciliations as well as differences in intercompany accounts that are frequent and significant. I determined that this was a material weakness, as the magnitude of a financial statement misstatement would reasonably be expected to be material (due to the intercompany transactions being frequently material). In addition, the company’s controls would reasonably be expected to fail to prevent or detect the misstatements, since the identified differences in intercompany accounts are frequent and significant. I recommend that management immediately develop and implement a formal process that includes leadership accountability measures to ensure that reconciliations are performed regularly.
In addition, Earth Wear did not effectively perform control activities related to year-end accruals. Specifically, there was a lack of adequate cut-off procedures to ensure the timely recording of certain period-end accruals. This resulted in an audit adjustment of $3.578 million. I determined that this is a material weakness, as the audit adjustment exceeded the overall materiality threshold of $3.51 million (Rainey, 2017) and the company’s controls failed to prevent or detect the misstatements. We recommendation is that Earth Wear make the audit adjustment and implement leadership accountability measures to ensure timely recording of period-end accruals.
Further, Earth Wear did not effectively perform control activities related to reconciliations between the general ledger and subsidiary ledgers in a timely manner. Specifically, the accounts receivable subsidiary ledgers are not reconciled to the general ledger account in a timely and accurate manner. There is a formal policy for reconciliations; however, there is no formal process or procedure that is followed to complete this task. As a result, differences between the subsidiaries and ledger accounts required an audit adjustment of $376,000. I determined that this is a significant deficiency. Although the adjustments fell below the tolerable misstatement of $1.55 million (Rainey, 2017), there is a reasonable possibility that the company’s controls will fail to prevent or detect a material misstatement of this account balance. I recommend that Earth Wear implement a procedure to ensure timely and accurate reconciliations between the general ledger and subsidiary ledgers.
Finally, Earth Wear did not effectively deploy control activities to ensure that information contained in the financial records was accurate. As a result, there were several instances of transactions that were not properly recorded in subsidiary ledgers. I determined that this was a control deficiency, as the transactions in error were not material either individually or in aggregate. I recommend that Earth Wear implement procedures to review transactions in subsidiary ledgers for accuracy.
Information Systems and Communication: Earth Wear has implemented effective information systems and communication controls. The Board of Directors has created a five-year strategic plan and uses it with the budgeting process to identify information necessary to monitor progress toward objectives. There is also a strategic plan for updating the information systems for financial reporting, and this plan is revised on an annual basis (Messier, W. et.al, 2017b). Actual performance by departments is reported on a weekly and monthly basis, to be monitored by the Controller’s office. Employees are provided with information regarding their duties during initial training. The employee manual provides guidance on how to handle suspected violations of company policy, and there are procedures for anonymous reporting of suspected violations (Messier, W. et.al, 2017d). I did not note any gaps in internal control related to information systems and communication.
Monitoring Activities: Earth Wear conducts effective monitoring activities. There is an internal audit function, and management implements internal audit recommendations that they determine are cost effective (Messier, W. et.al, 2017b). In addition, the Board of Directors is very focused on the control environment and monitoring activities, meeting regularly with both the internal and external auditors. Although Earth Wear receives relatively few complaints from customers, all complaints are investigated for underlying causes and any internal control deficiencies are corrected (Messier, W. et.al, 2017c). I did not note any gaps in internal controls related to monitoring activities.
In conclusion, I found that Earth Wear has effective internal controls in place regarding risk assessment, information systems and communication, and monitoring activities. The control environment and control activities could be improved by developing a process for leadership succession, and by establishing leadership accountability measures to ensure compliance with existing policies related to reconciliations of intercompany accounts and timely recording of period-end accruals, developing and implementing a formal process for reconciliations between the general ledger and subsidiary ledgers to the general ledger, and implementing procedures to review subsidiary ledgers for accuracy. The final recommendation is to ensure all the changes that Earth Wear implements are in a written policy and procedure.