Objective
EarthWear Clothiers is expanding into the global market, and the risks associated with such a business strategy must be evaluated. It is Willis & Adams fiduciary responsibility to evaluate the internal and external factors with EarthWear Clothiers. This helps determine the audit plan and will ultimately advise on any recommendations for improving key internal controls. According to Audit Standard 2201.02, if there is more than one material weakness over financial reporting, it will not be deemed effective. Additionally, the AU-C §940.05 standard or the audit of internal control over financial reporting will be employed. The intent is to address the internal financial reporting risks that the control objectives intend to mitigate. Willis & Adams will go through the five internal controls, which include control environment, risk assessment, control activities, monitoring, and communication, and will provide recommendations for improvement of the existing practices.
Control Environment
One of the first components in the internal control system is the control environment. Unlike the other components within internal controls, this is a resultant of many factors which take place inside the entity (EarthWear Clothier). Generally, a company should have a system of controls that oversee the managerial process, for example, modeled by the Public Company Accounting Oversight Board Standard.
At EarthWear Clothier, they have a Board of Directors which meets each quarter to review the overall performance of the company. They review any significant transactions that have occurred within that quarter. The minutes are prepared by the corporate secretary, and the board signs them. An audit committee also meets prior to the board quarterly with both the internal and external auditors.
While Board members are an important part of any public company, there are a few risks within their control process. EarthWear Clothier has not provided a succession in leadership which is important if one of the key executives leaves for any reason. The Controller, Brad Norton, left his position in February 2016, and the position was not filled for over nine months. In November, they promoted Carol McKay, who spent the last 14 years with EarthWear, as the Vice President of External Reporting. This can cause conflict with their overall internal controls as Ms. McKay may not have the correct set of skills for the Controller position. These factors have increased risks of the control activities and risk of misstatements occurring. EarthWear Clothier needs to have a leadership succession to prevent issues with their overall controls. Additionally, EarthWear Clothier appears to have working papers with the conflict of interest policies outlined. Additionally, the leadership and the employees showcase the high moral standards and integrity in their work. The job descriptions of this business are concise and with sufficient detail, and the human resource practices are effective.
In general, the control environment of the EarthWear Clothier appears to be strong. One recommendation for improvement is the implementation of the succession in leadership strategy. Additionally, the company should implement a policy where the Controller’s position must be filled within a month after the previous leader has been reassigned to avoid leaving the organization without oversight. Additionally, the policy should include the set of skills and experience that the candidates for the Controler’s position must possess.
Risk Assessment
Risk assessment is the managements’ process of identifying any possible risks and verifying the likelihood and impact of a risk event (Risk Assessment, n.d.). The risk assessment needs to demonstrate objectives within the company, risks relating to their objectives, how risks are managed, assessing fraud risks, and how changes can impact internal control.
EarthWear Clothier has senior management who meet monthly to discuss any budgets and events which may affect the company. They have a Strategic Risk Management Committee that is responsible for overseeing the company and future events. Willis & Adams note weakness in the manufacturing aspect. They have one manufacturer and one intermediary, which accounts for over 80% of the company’s merchandise imported from other countries. EarthWear Clothier has numerous manufacturers in other countries, which helps with cost but can also cause problems with outsourcing if/when they no longer supply merchandise. Trade costs and policies may affect these amounts as well. Willis & Adams notes there are not any gaps in the risk assessment with internal controls.
The risk assessment showcases that EarthWear Clothier has a good strategy, with a few exceptions. The assets, liabilities, key customers, revenue, and organizational structure present no concern for the auditor. However, the key suppliers and their location is a major risk to the stability of the company’s operations. EarthWear Clothier should improve their supply chain management strategy and have more diversity with the manufacturers and intermediaries supplying the merchandise. Additionally, the location of the key suppliers in the states of Eastern Europe is another concern because of the restrictive legislation systems and political instability.
Information System
Information Systems environment is the examination of information systems, IT, inputs, outputs, and processing. EarthWear Clothier has a five-year strategic business plan that has goals with products, growth, and overall responsibilities. EarthWear Clothier should follow principles to be effective, which include obtaining relevant and quality information, communicating objectives and communications, and communicating to external parties affecting functions in internal controls (Messier, 2017). Willis & Adams recommends EarthWear Clothier to make sure at month-end the books are closed, and every record is posted accurately. This should be addressed to employees so they know what should be expected every month along with policies and procedures.
Controls should be in place for their accounting procedures to avoid posting transactions in incorrect periods. EarthWear Clothier has had several instances where financial information was posted in the wrong accounting period causing numerous material misstatements. There should be segregation of duties to make sure records are kept and up to date with any financial transactions. System tests should be performed as a new system was implemented in 2015. Because this system is new, and employees are learning, there should be a plan in place to review and revise anything necessary. Any revisions should have proper documentation.
Generally, EarthWear Clothier’s information system management meets the requirements of the COSO Internal Control framework. This framework implies that a company uses relevant information to communicate both internally and externally when managing its information systems (COSO, 2019). Based on this audit analysis, EarthWear Clothier’s information system is up to date with the requirements, presents no concerns or risks, and therefore, no improvements are necessary.
Control Activities
Control activities are procedures that help the management ensure that the company’s objectives are attained, and risks are addressed. EarthWear Clothier control activities are used to establish policies and procedures to help management make sure their directions are implemented. Control activities include verifications, authorizations, reconciliations, reviews, and segregation of duties. This helps with the principles of the company to develop control activities and create policies to put into action.
Several weaknesses were noted in Willis & Adams findings:
- A material weakness as improperly recorded transactions in subsidiary
- Lack of cut-off procedures with timely records and accruals.
- Account receivable subsidiary ledgers are not reconciled monthly even with policies set in place. As a result, an adjustment of $376,000 was made.
- Lack of cut of procedures for timely records of period-end accruals resulted in a $3.5M adjustment. This is a material weakness.
To maintain proper controls, Willis & Adams recommends additional procedures be put into place when it comes to recording transactions in the subsidiary accounts. Transactions must be entered in a timely manner to properly record entries. Segregation of duties should be put into place to ensure there is a proper chain of commands with approvals. A formal plan should be developed. A formal management policy for the reconciliation of intercompany accounts will help improve the control activities and mitigate the issues described above. Additionally, there should be a process for ensuring that these audits are performed routinely. Thus, the current control activities of EarthWear Clothier require attention and improvement as this is the biggest area of risk and concern for the business.
Monitoring Activities
Monitoring activities are intended to assess quality control of the internal control’s performance over time. EarthWear Clothier has an auditing committee, Board of Directors, non-management directors, which meet quarterly to review controls with internal and external auditors. By EarthWear Clothier monitoring controls, they can provide reasonable assurance. Additionally, operating effectively will reduce overall risks within the company. Monitoring activities means EarthWear Clothier should develop and perform ongoing evaluations to determine internal control are active and functioning properly. They should evaluate and communicate all internal control deficiencies as soon as possible to correct any actions (Messier, 2017).
Willis & Adams recommends internal audits be performed on different areas of EarthWear Clothiers. The internal auditor should test controls to determine accuracy and efficiency. If any changes occur, it should be discussed, and changes should be implemented accordingly. Customer complaints are low and relate to delays in receiving goods as well as occasional minor billing discrepancies. Complaints are investigated and corrected, and recommendations are brought to the quarterly meetings to discuss any possible implementations.
Some recommendations for improvement include the recommendation to enhance monitoring by establishing quarterly meetings between the monitoring committee and the internal and external auditors. The committee members must be from outside of the business management to ensure that they present their independent opinion. In general, the current monitoring activities that this company has are sufficient and allow for the leadership’s control and monitoring of the internal processes.
References
COSO. (2019). COSO Internal Control-Integrated Framework: An implementation guide for the healthcare provider industry. Web.
EarthWear Clothier’s. (2017). Web.
Messier, Jr., W.F., Glover, S.M., and Prawitt, D. F. (2017). Auditing & Assurance Services: A systematic approach (10th ed.). McGraw-Hill.
Risk Assessment. (n.d.). Internal audit. Web.
Willis&Adams, CPA’s. (2017). Web.