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Easy Clean, Co: Evaluation of Internal Control Environment Essay

LEARNING OBJECTIVES

Evaluate a new audit client’s control environment.

Provide an initial evaluation of certain components of the client’s control environment

Appreciate the judgment involved in evaluating the overall internal control environment based on interview data

Provide support for your internal control assessments

Ted is a manager in the Business Advisory and Assurance Services division of a national public accounting firm. He has been given the job of managing the audit of Easy Clean, Co., which provides industrial and domestic carpet steam-cleaning services. Easy Clean has never been audited. Thus, Ted does not have any prior-year working papers to review. Ted recently conducted a preliminary interview with Doug Dosio, who along with his brother, Phil, owns Easy Clean. Ted’s objective for the interview was to establish an understanding of the control environment. To prepare for his interview, Ted reviewed professional auditing standards. Those auditing standards (AU 319) indicate that the control environment “sets the tone of an organization, influencing the control consciousness of its people. It is the foundation for all other components of internal control, providing discipline and structure.” The standards state that control environment factors include the following:

1. Integrity and ethical values
2. Commitment to competence
3. Board of directors or audit committee participation
4. Management’s philosophy and operating style
5. Organizational structure
6. Assignment of authority and responsibility
7. Human resource policies and practices

Based on the interview dialogue provided below, you will be asked to evaluate the seven components of the client’s control environment noted previously in order for you to make an evaluation of the overall internal control environment. Before reading the interview information, please spend a couple of minutes reviewing the assessments you will make. Based on the information provided in the interview that follows, you are to evaluate Easy Clean’s overall control environment. To assist you in making this overall assessment, you will find detailed descriptions of factors noted below that may weaken or strengthen each of the seven components comprising the overall control environment.

INTERVIEW WITH CLIENT

Ted:Doug, can you give me a little information on the background of Easy Clean? Doug: Easy Clean provides both a domestic and industrial carpet steam-cleaning service and sells a relatively small amount of inventory, such as spot removers and carpet fresheners. Our company provides this service throughout three counties, which cover over 40 townships in a densely populated area. Easy Clean is completely owned by Phil and me. Our business has grown steadily over the course of several years after starting out with just one car-pulled trailer over five years ago. Over the years, the business has gradually added 12 fully equipped vans, worth about $30,000 each. Now in our sixth year of business, we plan to purchase approximately one new van each year to meet the growing demand for our services. The company grossed just over $1,650,000 in revenues last year, about half of which was collected in cash. We feel our continuing success is due in large part to “word of mouth.” Ted: Can you tell me something about the day-to-day operations?

Doug: Well, Mr. Day, our office manager, and I are in charge of a small sales force that goes out on leads to give estimates for new jobs. Mr. Day is paid a salary plus a percentage of the total sales each month. My brother, Phil, is usually out in the field managing the 20 employees who work as cleaners for Easy Clean. Phil also helps with managerial and operating decisions. Salespeople are paid on a commission basis, selling both the domestic and industrial jobs based on standard prices established by the owners. Salespeople may sometimes negotiate special cut rates during the slower spring and fall seasons. Of course, these are almost always subject to approval by me or Mr. Day. Large industrial jobs are typically booked well in advance of the actual work. The job commitments obtained by the salespeople are normally submitted to Mr. Day, who signs them to indicate his approval and then returns them to the salespeople.

Sales people then forward job commitments to one of two data input clerks for processing. The computer processes each commitment by extending the number of jobs by the standard price stored on the pricing file, or in specially negotiated situations, by the price on the input document. The sales, accounts receivable, and commitment files are updated and invoices are produced. An exception report of special prices is produced and sent to the salespeople to ensure that the specially negotiated commitments to jobs were processed correctly. Mr. Day developed this sales system himself and it’s working rather well. He’s currently in the process of creating the user manual for the system. I’ve also noticed that he sometimes makes adjustments to improve the system, which makes the accounting process more efficient.

We’ve agreed that he’ll reevaluate the process at least once every eight weeks. Ted: And how about your accounting department? How big is it, and who oversees the accounting process? Doug: The accounting department of Easy Clean consists of seven part-time clerks, including the two data input clerks, who are all paid an hourly wage. All except one are college students working toward their accounting degrees. Mr. Day trains all new accounting help when they are hired. Typically, they stay on with us until they graduate, which usually covers two full years. We keep them pretty busy around here, but everyone helps each other out and they always get the job done. Ted: What are your brother Phil’s responsibilities?

Doug: Phil manages the service component of the business. He usually trains all newly hired cleaning employees and explains their specific duties and responsibilities. When he feels sure that the employee is ready, the new hire is teamed up with a more experienced worker and assigned to a truck unit. When additional help is needed, Phil places ads in the local newspaper. Phil is the expert at running that end of the business. Ted: What about employee turnover?

Doug: We haven’t had a problem with employee turnover. Phil expects some turnover in this type of business and knows how to deal with it. We try to prevent any employee concerns by maintaining an open door policy and encouraging employees who have questions or concerns about their responsibilities to ask for help or to come talk with us. If a problem should arise that might affect others, Phil or I will immediately address the problem at the monthly office meeting, making all employees aware of the issue. Both Phil and I work hard to ensure that any problem is resolved promptly. Doug leaves to give an estimate and Ted continues his observations of the business.

Later that day, after spending time with the accounting staff, Ted has a moment to ask Mr. Day a few questions. Ted:Mr. Day, I’m wondering if you could help me clarify some things regarding my brief observations of the accounting staff? Mr. Day:Sure, I’d be glad to. What can I do for you?

Ted: I got the impression from the staff that they’re not always certain about their assigned functions. Are job responsibilities clearly defined? Mr. Day: In assigning office responsibilities, Doug says the main considerations are that work should be done by the people who are familiar with a task and who are capable of doing it. But, he also admits that availability has to be a consideration. Although this does lead to some overlap in duties, it doesn’t create any confusion in responsibilities.

I carefully assign the daily duties and overview each day’s accounting records. This keeps the office running smoothly and in a well-organized manner. Ted: The staff mentioned that they’ve occasionally had problems processing collections of trade receivables. Do you prelist cash receipts before they’re recorded? Mr. Day: Well, we haven’t really experienced any need to. The system is set up so that we collect all of the checks at the end of the day, making it possible to record them all at one time. This way, we can be more efficient by avoiding the need to write them down twice. On those rare occasions when there is a collection processing problem, we resolve it immediately. Ted: Do you ever run into accounting policy problems?

Mr. Day: Not very often. I usually handle any policy problems that do arise, although Doug will handle the situation if he feels strongly about the issue. Ted: Well, thank you Mr. Day. I need to talk to Doug before he leaves for the day. A few moments later, in Doug’s office…

Ted: Are you satisfied with the processing of trade receivables? Doug: Yes, definitely. Mr. Day is meticulous in his clerical operations, which is well systematized. He has excellent control over the trade receivables. In fact, it’s been over a year and a half since the bank accepted a list of pledged receivables as security for a loan. From then on, we’ve had access to a continually renewable loan based on a list that’s updated weekly. The loan is relatively small, and the contract allows the bank to access Easy Clean ‘s checking account in the unlikely event that collection of the loan seems doubtful. Perhaps I should add that although Phil and I have no formal accounting training and we have given Mr. Day full responsibility for the accounting duties, Phil and I are the only people allowed to sign company checks. Ted: One of the accounting clerks mentioned that you’re thinking about making a change in the accounting system. Doug: As a matter of fact, Mr. Day has been looking into using a new accounting software package that should make the bookkeeping process an easier task for the clerks.

This package includes a budgeting system that should help control costs and identify those areas that need attention. Although I’ve always monitored the company’s expenses, I didn’t previously see the need for a formal budgeting system. If something didn’t seem right, Phil or I would bring the problem up at the informal monthly office meeting between all the employees and try to resolve the issue. Given our current success, the implementation of a more sophisticated budgeting system seems like a wise investment. Ted: I’m also interested in your security measures. How do you protect your accounting records and physical assets? Doug: After hours, the office door and windows are heavily bolted. Only Phil, Mr. Day, and I have keys to open the office. Although there haven’t been any problems, we’re considering locking up the file cabinets where the hard copies of the accounting records and data disks are stored at night. I’ve also been meaning to see about having the computers bolted down to the desks. As for the vans, they’re kept in a fenced-in lot behind our office.

Each driver gets a key to the gate lock so they can let themselves in or out for work. We have to do this because a lot of the commercial cleaning is done after hours, when the office is closed. As a precautionary measure, we change the lock regularly. Ted: That should about do it for now, until I can get in to do some preliminary audit work. But before I leave, I’d like to ask you a few more general questions. To start with, can you tell me what you feel is responsible for Easy Clean’s recent success? Doug: Well, Ted, because Easy Clean is using the newest steam-cleaning procedure, we provide a much better result than the traditional rotary shampoo methods used by our competitors. And, our customers can tell. Plus, Phil and I understand the business well, we are personable, and we pride ourselves on doing good work.

Ted: Having an audit performed by our firm is a big step. Why did you decide to have an audit now? Have you ever been audited before? Doug: Phil and I are confident that Easy Clean is a truly viable concern. We feel that audited financial statements will corroborate our claim. We’re eager to learn what suggestions your firm can give us regarding the most professional way to record and present our financial statements. We also have an interest in learning how to increase the company’s credibility with the local business and banking community. Both Phil and I are excited about the success of our company and we’re motivated to continue strengthening the organization with the eventual goal of pursuing additional business opportunities and endeavors. We’ve never been audited before, although we have used a local tax preparer to fill out our tax returns ever since Easy Clean has been in business. We did ask another firm, about two years ago, to come in to do an audit.

We decided not to have the audit performed, though, because the company’s fees were too high. Although I’d have to look up the audit firm’s name, Phil and I decided that Easy Clean would have to wait for an audit until we could reasonably afford the fees. We’ve come to the decision that now is the time. Ted: Are there any issues of concern that you have regarding the audit? Doug: Not really. I’m proud of Easy Clean. The company has had no record of serious problems and has rarely had a problem with bad debts, since most of our receivable balances are collected within two to three weeks. Ted: I understand that Easy Clean does not have an audit committee, which is typical of an organization this size.

Can you tell me if Easy Clean has a board of directors and, if so, who serves on the board and how active the board is in overseeing important issues at Easy Clean? Doug: We do have a board of directors. It is somewhat informal, but Phil, I, and our wives function as directors. We do have at least one regularly scheduled meeting each year and we have met on other occasions as necessary. Obviously, Phil and I have a pretty good idea of what is happening at Easy Clean on a daily basis. We do not believe our company is yet at a stage that could effectively support a separate board comprised of outside directors. Maybe we’ll do that in a couple of years, if we keep growing.

Ted: One final thing I’d like to ask—have you and your brother Phil set out any goals for the future? Doug: Phil and I have spent a lot of time talking about our goals and objectives, but we’ve never formally recorded them anywhere. Our long-term goals are fairly uncertain, but we’re hoping to build our nest egg to the point where we can potentially retire early. We both agree that our future plans include expanding our sales territory, increasing advertising, investing more help and additional equipment, and, I have to admit, taking a well-deserved vacation in Hawaii.

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