The following report is focusing on the investigation of the internal control and its importance in carrying out auditing of the financial record of the company. The focus is on the case of CU limited which is involved in manufacturing the chemicals that are being used by the plastic industry. The evaluation of the inventory management practices of the company will be carried out with an aim of highlighting the weaknesses in the internal control and recommendations will be made to overcome those weaknesses. Further, the procedures that can be used by the internal auditors to identify weaknesses in the CU Limited’s internal system will be discussed in the current report. Finally the report will be concluded.

1.Evaluation of Internal Control Structures:

2.1 Internal Control:

Internal control of any organization is a dynamic integrated process that can be influenced by the decisions and actions of entity’s management and personnel, which has mainly been designed by the entity with an aim of addressing the risks and to assure that organization’s policies and practices are in compliance with the mission of the entity (Cosserat, Leung and Coram, 2001). The internal control of any organization is designed to achieve the following key objectives:

• To design and execute operations which are effective, ethical, efficient and economical for the organization.
• To fulfil financial and accounting obligations of the business through reliable reporting.
• To comply the policies and practices of the organization with laws and regulations.
• To provide the appropriate back up to company with an aim of protecting the resources from loss, misuse and damage.

The internal control is the dynamic process which changes as the organization responds to changing environmental conditions. There are five major components of the internal control which are needed to consider by the auditors while investigating the control structure of the organization (Gauthier, 2001). These five components include; control environment, risk assessment, control activities, information and communication and monitoring.

2.2 Importance of Studying Control Structures by Auditors:

The review of the internal control system of the organization has always been a significant task for the auditors due to legal and economic obligations. The investigation of the control environment of the firm allows the auditors to understand the integrity and ethical standards maintained by the focal company. Along with this the knowledge about the competence and commitment to the accounting principles and regulations can also be obtained through the assessment of control structures of the client firm which can be of greater assistance for the auditor, during the auditing of financial statements of the company (Ramsay et al., 2013). Moreover, the importance of studying the control structure of the focal firm lies in the notion that auditor can assess the risks associated with financial reporting and can devise the strategies to minimize the risk to the acceptable level. Therefore, the assessment of risk is an important factor for the auditor while making the auditing plan for the firm. In related vein, the examination of the control activities of the client’s firm assist in understanding the policies and practices that are being used by the management of the firm for reporting of financial data. It is an important factor for evaluating gaps in the existing recording and documentation of financial data by the focal firm and auditor can prioritize the areas of greater susceptibility by identifying weaknesses in the internal system of the firm. Furthermore, the investigation of communication and information system is important for knowing about the methods for recording and reporting of financial transaction through maintaining accountability internally in the organization (Gauthier, 2001). Finally, the auditor can investigate the internal auditing effectiveness of the client’s company which indicates the level of quality maintained in reporting of financial data. Therefore, all of these factors lying in the internal control structure of the focal auditing firm, provides a framework for the auditor to devise strategies and procedures before formally carrying out auditing of the financial data of the company.

According to Generally Accepted Auditing Standards, it is the key responsibility of the auditors to carefully examine the control system internally before conducting auditing of the financial statements (Kinney and Martin, 1994). According to the theorists of the auditing and internal control, the inspection of internal control of the company enables the auditors to carefully design their audit plan according to restrictions laid by the internal control system of company(Obaidat, 2007). Moreover, the auditing procedures cannot be same for all the companies and it depends on the internal control system of the company. The auditing procedures for the companies with the control system cannot be applied in the companies with the strong internal control system. Furthermore, the statements on the auditing standards require that the auditors need to communicate actively with the top management and board of the company during the evaluation of the internal control system with an aim of suggesting them improvements in the weak internal control.

There is also a pressure from law and regulatory authorities on the auditors to correctly inspect and identify the weaknesses in the internal system of the client which are needed to be reported later on in the auditing of financial system (Ramsay et al., 2013). If the auditor fails to meet the compliance with the regulations laid by internal auditing standards then he/she might face criminal charges. Therefore, it is crucial for the auditor to investigate the internal control system before conduction of formal auditing of financial statements of the client. Along with this, there is also an economic reason behind the investigation of control structures which lies in the fact that understanding of control structures enables the auditing firms to effectively audit the financial position of the company, which make them competitive in the market (Street and Gray, 2002). The reliance on internal control system of the focal firm allows the auditors to rely less on the substantive tests, which significantly reduces the cost of auditing and increase efficiency of the auditing.

In related vein, the risk of auditing is the combination of inherent risk, detection risk and control risk. The auditor’s study of the control structures enables him to investigate the level of control risk and if the focal firm is relying on strong procedures and there is little chance of errors and omissions then the scope of substantive testing can be reduced by the auditors (Roussey, 1996). Likewise, the study of internal control structures allows the auditors to identify the weaknesses and strength of the system and in this way the testing can be applied to those areas which are weak and the resources can be saved by focusing less on the areas which are strong according to the control structure implied by the organization. It has been highlighted by the practitioners that auditing of the organizations is difficult in the complex and large organizations (Smith, Sagafi-Nejad and Wang, 2008). Therefore, in the more complex organizations, it is important to deeply and closely examine the control structure of the organization rather than studying each and every transaction in detail which could be time consuming for the auditors.

2.Internal Control System of CU Ltd:

3.1 Weaknesses:

The internal control system of the CU Ltd is depicting few problems regarding the maintenance of ingredient inventory, maintenance material and supplies inventory. Some of the core problems include that in the company independent checks on performance are missing. It can be justified with the information that for receiving the raw material inventory items only one employee is there which is responsible for receiving and moving the material to the batching department. It has been mentioned by the researchers that it is not appropriate to relysolely on employee for inventory record keeping because employees may become negligent and it can create problems for recording of the inventory during internal control of the company.

Along with this, the internal control system of the company is lacking in terms of maintaining control over the physical assets of the CU ltd. It can be seen in the information given by internal auditing department that the key responsibility of keeping the record of maintenance parts and supplies inventory is of clerk of the store room. The absence of clerk is the common phenomenon which can cause missing details for the supplies inventory or material that goes out of the store. It could cause the company to face problems in maintaining the record which can be easily captured by the external auditors and can create issue for company in terms of failure to maintain transparency in its financial reporting.

Similarly, it is evident that in case of raw material inventory and supply inventory the documentation of the company is not immediately followed by the operations and it can cause the missed details when recording at later stage. It has been highlighted by the research on internal control system that there should be a minimum time lag between the occurrence of transaction and recording of the transaction (Mennicken, 2008). This aspect seems to be missing in case of CU Ltd where usage of inventory is recorded on weekly basis in the light of finished products of the company. Therefore, the inventory that is not consumed for finished good but it get waste during the production is not considered by the management during the record keeping of the inventory. Similarly, the maintenance material and inventory supplies that are being taken from the store room in the absence of the store clerk are not recorded in the financial reports. The cost of these materials is not included in the statements and therefore, the presented financial position of the company is not true and actual. Therefore, it is a challenging task for the management and internal audit committee of the Cu Ltd to overcome the weaknesses related to reporting procedures of the company. It is evident from the research that gaps in documentation can cause the problems of material misstatement in the financial reporting related to inventory.

3.2 Recommendations:

On the basis of weaknesses in the internal control system of the CU ltd, it has been recommended to them that the management need to maintain the strict control over the inventory management procedures. There is a greater need to increase the sense of accountability and there should be procedures to immediately record the occurrences of the transactions (International Federation of Accountants, 2007). The employees should be trained to incorporate the rush order’s details into the financial reporting with as near transaction time as possible. Moreover, there should be an appropriate procedure for approaching the physical assets by the employees when required. In CU ltd the supplies and maintenance material can be easily obtained from the store room and it can cause the wastage of material. Therefore, there is a greater need for the company to devise integrated procedures which reduces wastage and enables the company to maintain record of each and every transaction. Along with this, the company needs to monitor the activities and policies regarding recording and reporting of inventory on ongoing basis with an aim of revisiting the operating activities of the entity. It has also been recommended to the CU limited to incorporate the reconciliation of their inventory management system with an aim of investigating that weather the record of the inventory is incorporating all necessary transportation of inventory into account or not. Finally the company have the option to adopt the system of record keeping that records any item taken from the stock of inventory immediately and then compare it with the number of finished goods that are completed by using raw material from inventory items. Along with raw material inventory the greater needs of maintaining supplies inventory demands the greater attention of management due to the cost that can be incurred due to loss of maintenance and supply inventory.

3.Identification of Weaknesses in Internal Control System of CU:

With an aim of investigating the weaknesses in the internal control of the CU Ltd., the internal auditors can follow the cut off analysis (International Federation of Accountants, 2007; Ramsay et al., 2013). In the cut off analysis, the internal auditors can halt the procedure of the inventory counting and can exclude the extraneous inventory items. Moreover, they can incorporate receiving and shipping details to check whether the details of inventory has been incorporated by the management or not. Moreover, the internal control auditors can reconcile the inventory count to the general ledger. It can be done by valuation compiled through inventory count to check whether the counted inventory matches with the accounting record of the company or not. By following these procedures if the internal auditors finds out that the counting balance of the inventory is not matching with the recorded inventory than it could be considered as the alarming situation for the company to revisit their inventory management system with an of improving their accounting procedures.

Along with this, the level of materiality can be calculated by the internal auditors with an aim of investigating the omissions related to the recording of data.The materiality level is the threshold value of the misstatements in the financial statements that can be tolerated(Combarros, 2000). In the current case of CU Ltd. the internal auditors can investigate the accepted omission value for the level of inventory and then they can track the record maintained by the management with an aim of investigating the difference in the accepted level of materiality and actual omission rate. It would serve as the logical ground for the internal auditors of the CU limited to investigate the gaps in the recording and reporting procedures of the company related to inventory management.

Finally the internal control system of the CU limited is weak in terms of reporting the accurate and timely decisions and internal auditors of the company can continually monitor the reporting of the financial data related to inventory of the raw material and supplies. Continuous monitoring and control will enable the internal auditors of the company to not only identify the problems in the recording of inventory but it will also allow them to take corrective actions with an aim of improving the inventory control system of the company.

4.Conclusion:

In conclusion, the current report moves around the problems in internal control of the CU Limited regarding the management of inventory. It has been carried out in three different sections. Firstly the internal control has been defined in detail along with the need for the auditors to study the internal control system of the company. Different benefits and requirements of investigating the internal control system by the auditors have been mentioned in this part. Secondly the problems in the inventory management of the CU Limited has been discussed in greater detail and recommendations have been made to the management to overcome these issues. Finally, the study has incorporated the procedure that can be used by the internal auditors to identify the weaknesses in the inventory management system, of the company has been detailed.

References:

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Street, D.L. and Gray, S.J., 2002. Factors influencing the extent of corporate compliance with International Accounting Standards: summary of a research monograph. Journal of International Accounting, Auditing and Taxation, 11(1), pp.51-76