Ateneo de Davao University School of Business and Governance E.

Jacinto Street, Davao City

In Partial Fulfillment of the Requirements In IT 2 - Accounting Information System

Bern Fly Rod Company An Internal Control Case

Submitted to John Karlo S. Dalangin, CPA

Proponents Arcinas, Erwin Lucky Bretaa, Denee Vi De Gracia, Mikhail Rey Macarayo, Andrew Pelegrino, Floreza Mae

An effective internal control leaves only a little opportunity for fraudulent activities to exist. As in the triangle of fraud, the internal control of the company is directly exposed to situational pressures, opportunity for fraud, and low personal ethics. In the context of Bern Fly Rod Company, the proponents have observed that there is a great possibility of the existence of fraudulent activities based from the triangle of fraud. The situational pressures arising from the desire of having a higher commission based on sales orders placed by the sales persons plus the opportunities to commit fraud bolstered by the employees low employee ethics, the existence of employee fraud cannot simply be neglected. Having these as the premises of the case, the proponents would like to present the following issues and proposals to mitigate or avoid its unwanted effects in the company. 1. Expense Reimbursement One of the issues the proponents of this case realized is that the company does not require its sales agents to submit supporting documents or receipts of their travel expenses together with their hard-copy file spreadsheet of expenses, thus, this scheme is prone to employee fraud. The employee may claim for reimbursement of personal, fictitious or inflated business expenses, this includes reimbursement of travel expenses which are not necessary in the ordinary course of business or which are not in pursuit of the employers trade. With this, there is an opportunity to commit fraud specifically the reimbursement of expenses fraud. Since the companys travel expenses are disproportionately high in the month ended October 31 compared with the previous months, there is a great possibility that the travel expenses might be manipulated and charged at a higher cost. If this issue will not be addressed, the companys profit will be understated because they will be paying expenses which are inexistent or not for their business. There is a high probability that its current net income will not reflect the real income and financial performance of the company. If the profit is low, it is not desirable for the owner Bern Fly Rod and its stakeholders.

Recommendation: With this issue, the proponents proposed that the company must require its sales persons to submit together with their hard-copy spreadsheet the receipts that could support the figures therein. The receipts must be duly authorized by the person or the company issuing it. The hard-copy spreadsheet must also contain details that are important in determining if the expenses are really necessary for the companys trade. If this course of action will be taken by the company, the risk of having fraudulent transactions with regards to expense reimbursements will be minimized and the sales person will now find it hard to record fraudulent, fictitious and inflated travel expenses. If the risk of having fraudulent records will be reduced, then the company can assure that the reported net income is the real net income of the company and is reflective of the companys financial performance. On the other hand, if they will not do some actions concerning this issue, the company might continue recording fictional transactions which have an adverse effect in their financial performance. 2. Compensation Scheme The compensation of a sales person is directly proportional to the figures in its orders. The figures themselves are prepared by the salespersons, as assumed to be true due to absence of that which leads to the contrary, which are then submitted for prompt disbursement of the sales commission. In addition, the sales persons are also reimbursed for their travel expenses after submitting the hard copies of the spreadsheets to the disbursements clerk. Furthermore, amounts are identified and are, again, promptly paid to the salespersons concerned. This compensation/commission scheme raises a series of extensive issues with regards to fraudulent activities from the sales staff. The sales staff may choose to play with the figures in the orders that they submit to the disbursements clerk. The same may likely seem to occur in the compensation of their travel expenses.

Another set in the said series of unwanted events that may arise from its compensation scheme is the effect of their failure to consider the product returns. It would be unfair for the company who promptly gives commission to its agents for their sales without taking into consideration the product returns because what they are paying is too much since the net sales that they have recorded is lower than the sales that have been reported by the agents. It would show that the company is paying large commissions when in fact it should not be the case. With this, the company pays more than what is reasonable and necessary and if we would take a look at the efficiency principle in business it focuses on conducting business at a lowest possible cost. Recommendation: The first proposed action of the proponents with regards to this particular issue is a very, rather, theoretical and basic measure which is simply the segregation of duties. For the first part, there is no mention in the case concerning who fills up the orders that are submitted by the salespersons to the disbursements clerk for the payment of sales commissions. The filling out of order forms must be separated from the duty of the sales person so that there can be a segregation of duty. In doing so, the sales persons opportunity to manipulate the sales figures can be lessened or reduced into an acceptable level. Measures must also be done to check whether the sales commission that these sales persons were receiving are reasonable and that these figures could possibly indicate the performance of such sales person because the sales person might be receiving huge amounts of sales commission annually if taken from the angle of his gross sales order contribution but when the angle is from the net sales contribution to the operation it might imply otherwise. The question now would veer on how the company would implement this proposal. One way is, before the prompt payment of the necessary sales commission, the management or its financial managers must evaluate the performance of this sales person,

and check whether the actual figures is in proportion with the gross or net sales commission they are receiving, and they must handle a thorough and refined process of commission schemes. Furthermore, the weekly issuance of check for the reimbursements must be changed into monthly time sequence to provide more time for evaluation though the submission of the spreadsheets can be done weekly. 3. Weakness in internal control There is an apparent weakness in internal control of the company specifically because the person who is receiving the request for reimbursement of the necessary expenses by the salesperson and the one issuing the check for the same is just one and the same person or clerk. With this fact and problem in hand, the disbursements clerk, in fact, can just easily place an overstated cost of reimbursement to benefit himself. He could also collude with other employees so that while he is benefitting from this fraud, the employees which he is in connivance with will also benefit. And if both of the parties are benefitting from this fraud, theres a little chance that anyone will tell this fraudulent transaction to the management. Now, together with this problem is also the concern that the salesperson who receives the check can just alter what is written on the check, assuming the checks are manually filled-up. Recommendation: To avoid the abovementioned effects in the weakness of the companys internal control, the team would like to propose that the management should impose a proper segregation of duties specifically in the area of disbursing the travel expense reimbursements. In order to execute this proposal, first, there must be competent and independent persons who will handle the receiving, recording, and authorizing function of the reimbursement process for every trip of the sales agent. Every authorized trip must be recorded with proper and supplementary documents for verification and audit trail purposes. Second, the

person handling the recording must preferably come from the firms accounting department, who will record the hard-copy spreadsheet of expenses with all the necessary documents and receipts of the sales agents trip. The accounting staff will now verify or check if the sales agents transactions or trips were previously authorized by looking at the records made by the officer authorizing the trips. After verifying the said expenses, the accounting staff will send a request for approval of reimbursement to the person who is vested with the authorization function. Third, the person who is vested with the authority to approve disbursements will now give a discharge order to the custodian of the fund to issue a check to the salesperson. With this procedure, the management can ascertain that the travel expenses incurred by the sales agents were made in the pursuit of the firms business and that the duties are now properly segregated in order to avoid the possibility of having fraudulent and unreasonable disbursements of cash. In response to incidental concern of this issue, the company must make sure that the checks issued to the salesperson are computerized and that amounts placed in the checks must be recorded and there must be a monthly reconciliation and checking of the amounts disbursed by the banks for the checks issued for sales compensation. Through the previously said proposal, possible alteration of amounts may be intercepted and fast checking of actual disbursed funds based on the budgeted or approved amount will be done. 4. Billing Scheme: Shell company fraud The salespeople, with the motive of increasing sales orders to obtain a higher amount of sales commission, might opt to commit this type of fraud. The sales person, with the help of a sophisticated computer technology, may penetrate the companys system through the establishment of a false buyer on the books of Bern Fly Rod Company. The false buyer triggers Bern Fly Rod Company systems to create false sales orders at which point submits them to the accounting system of the victim company. This allows the false buyer to create an illusion of an existing and legal transaction. Because of the documents

submitted to the victim companys accounting system, it will automatically set up a fraudulent receivable to be sent directly to the billing department where the sale is recorded and then to the shipping department for delivery to the false customer. If the management does not act on this issue as soon as possible, the company might find itself on the losing circle of companies due to unaddressed weak internal control in the company. The effect of having a fictitious customer or buyer is pervasive that it does not affect only the sales order account of the company but also the entire financial system, who knows, the company might just be living one day in a belief that it is progressing and booming where in fact it is not. Recommendation: In order to address this issue, the proponents would like to propose that the company should install and maintain a detective control procedure to the billing process to confirm the validity and existence of any such order. In order to implement the abovementioned proposal, the management, through its accounting department, must make a weekly confirmation report on the actuality of such customers and the information regarding the inventory volume because it is in the belief of the proponents of this case that the sales orders which are finalized and the volume of inventory the company has must go together. Furthermore, the sales orders should also contain all the necessary client information such as the clients contact details. This course of action would appear to be less costly and with greater emphasis on the preventive and detective control. It is preventive in the sense that its sales orders are so welldesigned that it reduces the possibility of employee fraud. It is also a form of detective control in a way that it involves confirming the existence and validity of the submitted sales orders to the company through direct communication with the client. It contributes therefore to the effectiveness of the internal control policy of Bern Fly Rod Company. If the company will not place any emphasis on its strictness towards this issue, they would become more susceptible to further abuse, thereby allowing

more sales persons to usurp from the financial assets of the company, countenancing losses by giving out sales commissions which arent reasonable and necessary due to fraudulent transactions.

Source: Accounting Information System by James Hall