Topic: Violations of Internal Control
Characters: William Dalton, President of Dalton Enterprises, Inc.; Chauncy Dalton, VP of Finance and future President; Tim Johnson, In-charge CPA George Smerlas, Controller
Tim Johnson, CPA, is the senior in-charge on an audit of a medium sized ($20M in assets) client, Dalton Enterprises, Inc. This client is a family owned and operated corporation. Mr. William Dalton (67 years old) is the president who micro manages all aspects of the business except the finance area, which he leaves entirely to his son, Chauncy, who has been newly appointed as the VP of Finance. Chauncy, recently graduated with an MBA, and majoring in finance, is responsible for administering all the financial and accounting aspects of the business including the appointment of the auditors. Chauncy replaced Herb Castle who retired after thirty years with the organization. George Smerlas as controller reports directly to Chauncy.
The audit report has never circulated outside the organization. The report provides a basis for the tax return which George prepares. It also provides Mr. Dalton with supplemental schedules including comparative aging schedules and a detail comparative listing along with the changes in all of the general ledger accounts. Mr. Dalton used the audit report, along with the management letter, for administrative control purposes.
While analyzing the travel and entertainment expenditures, which were substantially ($20,000) higher than last year’s amount, Tim noted that most of the increase was attributable to payments made on Chauncy’s behalf. The supporting documentation for these expenditures were very sketchy and in most cases, the only documentation was a check request initiated by Chauncy. All other T&E expenditures, including the modest payments on Mr. Dalton’s behalf, were properly documented. When queried about this documentation problem, George acknowledged that the company’s policy of having the immediate supervisor of the person requesting payment for T&E approve the voucher were circumvented here. But considering the circumstances, George was not concerned about the problem. When asked about the $25,000 travel advance due from Chauncy, George replied, “He signed your confirmation request acknowledging the amount due, didn’t he?”
Tim decided to discuss the problem of lack of approvals and documentation with Chauncy. Chauncy’s response was to questions why the auditors would be skeptical of his honesty and motives here. He also stated that it was typical of “bean counters” to pursue areas that are of little significance, while ignoring areas where efficiency could be improved. He ended the interview by asking, “What are we paying you guys for anyhow?”
All other audit areas and financial statement disclosures are deemed satisfactory.
Author: Robert R Davis, Associate Professor of Accounting, Canisius College
What Are the Relevant Facts?
- The company (Mr. Dalton) relies upon the audit report for tax preparation and administrative control purposes.
- Chauncy Dalton appears to be defensive to questions regarding personal accounting transactions.
- Chauncy Dalton has the power to appoint the auditing firm.
- Personal items may be disguised as business and tax deductions.
- Chauncy Dalton’s compensation may be
understated because of the possibility of personal expenditures listed as T&E.
- The $25,000 travel advance may not be an asset.
- Internal control procedures have been overridden by top management.
What Are the Ethical Issues?
- Is the audit going to be conducted in accordance with GAAS?
- Will the deviations from internal control be addressed in the management letter?
- Should Tim discuss the T&E issues with Mr. Dalton?
Who Are the Primary Stakeholders?
- Dalton Enterprises, Inc.
- Chauncy Dalton
- George Smerlas
- Tim Johnson
- Tim’s firm
What Are the Possible Alternatives?
- Propose reclassifying the T &E as personal.
- Modify the audit report.
- Outline the deviations in the management letter.
- Have the engagement partner discuss the issue with William Dalton.
- Set up the uncleared T&E expenditures as a receivable.
- Propose no adjustments to the T &E balance.
What Are the Ethics of the Alternatives?
- Ask questions based on the utilitarian perspective (moral behavior that produces the greatest good for the greatest number). For example:
- Chauncy’s current behavior appears to only benefit himself at the expense of all other stakeholders.
- If the ME ocpenditures are in fact legitimate and treated as personal, the company’s earnings and tax liabilities are overstated (costs) in order to satisfy the spirit of an internal control policy (benefit).
- Are there long-term benefits to all stakeholders by establishing the proper role of the auditor in monitoring all aspects of internal control compliance?
- Ask questions based on the “Rights and Duties” perspective–moral behavior that takes into account the moral rights belonging to each stakeholder and the duty each one owes to the other and the relative weight of these rights and duties. For example:
- Whose rights, if any, are violated in each alternative?
- What duties do Tim Johnson and his firm have in this scenario?
- What does each stakeholder in this scenario have the right to expect?
- Ask questions based on the “Justice” perspective-moral behavior based on an examination of alternatives that distribute the benefits and burdens among the stakeholders in a way that is fair or unfair, just or unjust. For example:
- For each decision to be made by Tim, the controller, and the CPA firm, which alternative distributes the benefits and burdens most fairly among the stakeholders?
What Are the Practical Constraints?
- Since Chauncy is the heir apparent to operating the corporation, the risk of alienating him may cause the appointment of new auditors now or in the immediate future.
- Without proper documentation supporting the T&E expenditures, it may not be prudent to assume that these expenditures are not proper.
- The expenditures may never be subject to an IRS audit.
What Actions Should Be Taken?
- What action should Tim take?
- What alternatives would you choose if you were in his position? Why would you make that choice?
What ethical theories (utilitarian, rights, justice) make the most sense to you as they relate to this situation?