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Internal Control Weaknesses and Fraud Risks at Alchemy, Inc.

发布时间:2017-03-04
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Alchemy Memorandum

Date: April 22nd, 2014

To: Engagement Partner

From:

Subject: Internal Control Weaknesses and Fraud Risks at Alchemy, Inc.

Alchemy, Inc. is a wholly owned subsidiary of Al Chem Corporation that specializes in the processing of small gold spheres used in the aerospace industry. Alchemy records revenue when spheres are processed, as opposed to when they are sold. Following a comprehensive review of Alchemy Inc.’s internal controls, it has become apparent that the organization’s processes and procedures provide ample motivation, opportunity, and rationalization for fraud in a number of areas. An analysis of Alchemy Inc.’s significant control weaknesses and fraud risks, as well as associated recommendations, is as follows:

Lack of Proper Expertise: While the Internal Auditor is very educated on many different topics; he claims to have a "CPA" which he got online in 2.5 days. Furthermore, his staff consists of recently graduated non-CPA college students with little to no work experience and admittedly no proper training.

Control Weakness: The validity of the internal auditor’s CPA is questionable, and his staff consisting solely of recent college graduates lacks experience. An internal auditor should have proper expertise on such subjects alongside an actual CPA. Improperly trained internal audit staff with no previous work experience may not be able to recognize risk areas or weaknesses within an organization. As such, the Internal Audit team’s lack of proper experience drastically reduces their ability to prevent or detect a material misstatement and/or fraudulent activity.

Fraud risk: The fact that such an inexperienced team was hired to assess Alchemy Inc.’s controls is indeed a fraud risk. Intentionally hiring an inexperienced team may be an attempt to prevent fraudulent behavior from being discovered, as an inexperienced internal audit team is likely to unknowingly overlook potentially suspicious activities.

Recommendation: It is recommended that Alchemy, Inc. hire qualified individuals with valid, relevant experience in the field of audit. While hiring recent college graduates is acceptable, it is imperative that the internal audit team is also comprised of a number of individuals with several years of audit experience. Furthermore, proper training must be provided to ensure that all team members are prepared for the job. Finally, it is recommended that Alchemy, Inc. ensure their lead internal auditor is indeed a CPA (has passed the CPA exam, is up-to-date on his qualifications, etc.).

Lack of Separation of Duties: Ben Eaze, supervisor of Receiving, Operations, and Shipping Departments, picks up the logs of the Machine operator, Shipping Clerk, and the Receiving Clerk.

Control Weakness: Ben Eaze is the supervisor for the Receiving, operations, and Shipping Departments. As such, Ben collects the manual logs of the operators in each of these departments on a weekly basis. This is a significant control weakness because there is no separation of duties, and seemingly no controls in place to mitigate any type of fraud risk. It is unclear what Ben does with the logs that he collects.

Fraud Risk: The lack of separation of management duties within the receiving, operations, and shipping departments presents a significant fraud risk because it leaves ample opportunity for Ben to intentionally misstate or tamper with the logs. In doing so, Ben may be able to partake in substantial fraudulent activity, potentially leading to a material misstatement of financials.

Recommendation: It is recommended that the receiving, operations, and shipping departments have different supervisors, each of which would be responsible for collecting, signing, and dating the logs of his or her respective department on a daily, as opposed to weekly basis. This would hold individual supervisors directly accountable for his or her own department, and would require that logs from one department match logs from the other two, a practice which would eliminate much of the potential for fraudulent activity. It is also recommended that copies of the logs be made and kept in separate files, so if someone does decide to change the numbers around, they can show the original copy, signed and dated. Creating a structure with clearly separated duties will act as an effective control to mitigate this risk.

No Reconciliation of Spheres – Machine Operator to Shipping Clerk: At present, employees do not reconcile the differences between the number of spheres received by the machine operator and what is shipped out. The lack of reconciliation reduces the reliability of financial statement accounts such as inventory and COGS.

Control Weakness: No reconciliation is currently being done in an effort to ensure that the number of spheres that the machine operator receives equals the number of spheres that is shipped. This lack of reconciliation creates ample opportunity for employee theft to go unnoticed, as there is no control to detect fraudulent behavior. This leads to a high possibility of misstatements in the financial statements and is a significant control weakness for Alchemy, Inc.

Fraud Risk: This leads to a high possibility of misstatements in the financial statements and is a significant control weakness for Alchemy, Inc.

Recommendation: It is recommended that Alchemy develop a formal process of reconciliation. Detailed logs must be kept, and the logs of the machine operator must match those of the shipping clerk. In addition, separation of duties should exist, and each log should be signed and dated by each department’s manager.

Familial Conflict of Interest – Hiring Unqualified Relatives: The machine operator, who was hired despite the fact that she is color blind for a role that requires her to sort spheres by color, is the sister of Alchemy’s CEO. While it is certainly possible for siblings to work for the same organization, it is imperative that each employee be evaluated based upon individual qualifications for the role, as opposed to being evaluated by the potential employee’s relationship with the CEO.

Control Weakness: Familial relationships that lead the organization to hire an unqualified employee present a conflict of interest, which may pose a threat to the execution of objective and effective work. In this instance, the machine operator is color blind, yet her core job function surrounds her ability to separate spheres by color. The fact that the sister of the CEO was hired into a role for which she is unqualified presents a control risk for Alchemy, Inc.

Fraud risk: The objectivity of work is at risk, and, as a result, fraud is more likely to happen. More specifically, the machine operator’s inability to distinguish between color of spheres significantly increases the likelihood of inappropriately sorted materials. Furthermore, because the machine operator is directly related to the CEO, she may be motivated to conduct fraudulent activity in an effort to inflate the financials of her brother’s company.

Recommendation: It is recommended that each employee be evaluated for a role based off of his or her specific qualifications for the role, as opposed to his or her relation to an executive within the organization. In this specific instance, it is recommended that the relationship be disclosed to both the Audit Committee and Human Resources. Depending on the code of ethics and perceived risk of audit committee, either disallow or allow the situation to continue.

Machine Operator Incentives: The machine operator is compensated based off of the number of spheres that go through the helixination process, incentivizing her to send the maximum number of spheres through the process as possible, regardless of color.

Control Weakness: The compensation structure of the machine operator provides an incentive that is not aligned with the overall goal of the process. The machine operator holds sole responsibility to ensure that only spheres of the correct color are sent through the helixination process. Because her compensation structure incentivizes her to focus on quantity as opposed to accuracy, incentives and goals are misaligned, presenting a significant control risk.

Fraud Risk: The machine operator is directly incentivized to fraudulently classify spheres incorrectly. This may lead to increased costs and incorrect inventory accounting. Related to the fraud triangle, this weakness provides opportunity.

Recommendation: It is recommended that Alchemy reevaluate the machine operator’s incentives. Rather than being compensated on the number of spheres sent through the machine, she should be compensated based on accuracy. This will eliminate waste within the organization and better align the incentive with the overall goal of the process.

Machine Operator: Lack of Physical Inventory Count: At present, the machine operator does not count physical inventory, leaving significant room for fraud.

Control Weakness: At present, the machine operator role involves a number of manual processes, none of which include an actual count of physical inventory. This leaves a lot of room for fraud, particularly when no controls are in place to mitigate this risk (the spheres are not counted upon arrival, and are merely left in the facility if not processed before end of day).

Fraud Risk: The lack of physical inventory count presents a specific opportunity for the machine operator, or anyone with access to the facility, to commit theft. Spheres are not counted in any sort of reliable fashion upon arrival, presenting the opportunity for theft either prior to arrival or following arrival. Furthermore, if she is not able to complete her entire process for one bag by the end of the day, she merely leaves the bag in the facility for the remainder of the day. Many people, including maintenance staff and cleaning crews, have access to this facility, leaving ample opportunity for theft.

Recommendation: It is recommended that Alchemy implement processes and procedures surrounding keeping accurate count of physical inventory. Inventory should be counted immediately upon arrival into the facility by two separate parties, and should be re-counted upon departure, again by two separate parties, in order to prevent and detect fraudulent activity.

HR & Machine Operator - Missing Eye Exam Report: It becomes apparent that the machine operator had missing information from her HR file, particularly involving a missing eye exam. The ability to see appropriately, and to specifically distinguish between colors, is crucial to the machine operator job function. The missing information suggests a control weakness and fraud risk.

Control Weakness: The internal auditor acknowledges that, upon reviewing the machine operator’s HR file, it became apparent that her file was missing an eye exam report. The fact that an employee’s HR file is missing information that is crucial to her job function is a significant control weakness, as it indicates that the employee may not be qualified for the position and that no control is in place to detect this type of risk. The internal auditor did not practice due diligence in this instance. While there was indeed a slip of paper indicating that the employee has 20/20 vision, a full eye exam was not present.

Fraud Risk: The missing eye exam report is a fraud risk as it implies that the employee may have a vision problem, and that this report was knowingly eliminated from the file. As it turns out, the employee is colorblind. This is a significant fraud risk as the ability to distinguish between colors is key to the Machine Operator’s job function. Intentionally eliminating this from the employee’s file provides the opportunity for the employee to fraudulently separate spheres, which may lead to material misstatement.

Recommendation: It is recommended that controls be implemented to disallow employees from being hired without complete records in the HR system. Furthermore, an employee’s records must be signed off by management prior to employment, holding an individual directly accountable for any errors. Finally, it is imperative that employee records be audited appropriately to ensure all employees are qualified for their individual roles. Internal auditors should not accept slips of paper in place of official medical reports.

Audit Plan – CEO Involvement & Final Say: Currently at Alchemy, Inc., the CEO determines the content of the audit plan, a significant control and fraud risk.

Control Weakness: Currently at Alchemy, the CEO determines the content of the audit plan. By definition, internal auditors should be unbiased, and should design the audit plan along with the audit committee to ensure effectiveness and appropriateness. The fact that the CEO has the final say regarding the audit plan is a significant control risk as it directly prevents the Internal Audit team from detecting and preventing control weaknesses and fraudulent activity.

Fraud Risk: The fact that the CEO has the final say on the audit plan, and more specifically, the fact that the CEO re-directed the audit plan to focus on HR as opposed to the manufacturing process, is a significant fraud risk and a strong indication of potentially fraudulent activity. This practice provides the CEO with the opportunity to conceal potentially fraudulent activity from the internal audit team and the audit committee, which may lead to material misstatement in financials.

Recommendation: It is recommended that the internal audit team, together with the audit committee, hold the sole responsibility for and authority over designing and executing the audit plan. This will ensure independence and lack of bias, which is essential in preventing and detecting fraud.

Reporting Structure: Internal Auditor & CEO: The current structure at Alchemy, Inc. wherein the internal auditor reports directly into the CEO misaligns incentives.

Control Weakness: Currently, the internal auditor at Alchemy reports directly into the CEO. This is a weakness as it misaligns incentives. Internal Auditors must always be free of bias; however, in reporting directly into the CEO, the Internal Auditor will inherently be biased, as he/she is required to do as the CEO says.

Fraud Risk: This is a fraud risk as the internal auditor is required to do exactly as the CEO says, placing the company at great risk. The fact that the CEO specifically asks the internal auditor to exclude Appendix A from his report is a strong indication of potential fraudulent activity. Furthermore, the fact that the internal auditor is required to do this due to reporting structure both motivates and provides the opportunity for the Internal Auditor to commit fraud, specifically under the instruction of the CEO.

Recommendation: It is recommended that reporting lines be changed immediately. The Internal Auditor should report into an Audit Committee in order to eliminate this bias and the risk of fraudulent behavior.

No Safeguarding of Assets: The machine operator does not secure spheres when she leaves, leaving opportunity for theft.

Control Weakness: The Machine Operator leaves half-filled bags of spheres unattended overnight not locking or storing them in a secure place. Not securing the spheres invites theft, with little to no controls to mitigate this risk.

Fraud Risk: Upon the arrival at work the next morning, the cleaning crew has come in the night before to clean up. The cleaning crew has had the opportunity to steal spheres. Current employees could also come in and take spheres without anyone witnessing.

Recommendation: The Machine Operator should make sure the half-filled bags are locked and stored away prior to leaving for the night this will help with safeguarding the assets. Furthermore, when bags are left overnight, a thorough count should be conducted by two parties prior to leaving, then again conducted by two parties upon return, allowing Alchemy to detect whether theft has occurred.

Lack of Employee Knowledge - Code of Ethics: There seems to be a significant disconnect at Alchemy, Inc. between the executive leadership and the employees regarding the existence and contents of the Code of Ethics, a situation which must be addressed in an effort to prevent fraudulent activity.

Control Weakness: The CEO expressed an admiration for the company’s Code of Ethics. The employees on the other hand did not have the same admiration. Some of the employees had no idea there was a Code of Ethics and some just did not use them. Without this knowledge about the Code of Ethics it will be difficult to trust the employees with financial information or any of the assets. There is currently no control in place to ensure employees are aware of and acting according to the Code of Ethics.

Fraud Risk: When employees aren’t aware of what their behavior should be this allows them the opportunity to commit and conceal fraud, and provides a rationalization for doing so. Having a Code of Ethics as a guide and resource states the values and principles that are expected for employees. Employees’ acknowledging there is a Code of Ethics in place helps to diminish the thought or act of fraud, and specifically eliminates the rationalization factor.

Recommendation: Once an employee is hired, the human resources department should implement a Code of Ethics quiz that has to be taken. This will allow HR to track and monitor who has acknowledged the Code of Ethics. Furthermore, the Code of Ethics should be engrained in the culture of Alchemy. Signs should be visible within the factory, and continued training should be conducted as a reminder of its existence. It is also key that Alchemy practice a “Tone at the Top” methodology, and that the message cascades down to employees effectively. Because many employees do not have email, it is imperative that managers live by this message. Ensuring that employees are aware of and familiar with the Code of Ethics is paramount in confirming its effectiveness.

As illustrated above, Alchemy, Inc. has a number of control weaknesses and fraud risks, which may be significantly mitigated or eliminated by implementing the recommendations provided. It is imperative that Alchemy, Inc. adopts a “Tone Form the Top” methodology, and that the company’s executive management ensures that the internal controls mentioned above become a top priority. In doing so, we are confident that Alchemy, Inc. will be able to transform itself into an organization with strong internal controls, significantly mitigating and/or eliminating control weaknesses and fraud risks.

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