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KMI Manufacturing
While you have been working on preparing a budget for fiscal 2020 for KMI Inc., Mr. Cutter has been involved in several meetings with his bank. He is hoping that the bank will increase his borrowing facilities so that he can take advantage of robust demand for his products.
In addition to the master budget the bank has requested certain personal financial guarantees from Mr. Cutter and have also asked for more information on operations. They would like a fuller understanding of the daily flow of activities as well as the assignment of responsibility and control. They have scheduled a site visit so that they can observe KMI’s operations first hand.
Mr. Cutter has asked the external accountant (me) to be part of the site visit to help answer any questions the bank might have from the accounting operations and controls side.
On December 4th 2018, the site visit takes place with two bank employees, Mr. Cutter, me, and Sammy Shop (the shop manager) in attendance.
The visit goes quite well and the bankers are very impressed with KMI’s manufacturing process. Manufacturing operations appear to be running quite smoothly and throughput seems to be in line with other businesses of this type.
However, they are less impressed with the controls or lack thereof that appear to be lacking. This concerns them because they know that a significant lack of controls can lead to losses that will turn an acceptably profitable business into one that the bank will not wish to fund.
They have requested that Mr. Cutter to prepare a report outlining the steps that he will take to correct this key corporate deficiency. Mr. Cutter in turn asks Jerry the external accountant to tackle this task and to report back to him. Jerry is quite busy with tax time but he thinks that this is a perfect task to have his new accounting intern (you) complete.
To assist you, Jerry provides the following information based on his review of operations and on his last management letter addressing controls during the 2018 audit.
Purchase and Payment cycle
At present, goods are ordered as needed from two local suppliers. There has been no effort to maintain inventory on hand as the suppliers have generally been able to meet demand as needed. On occasion, but not often this has caused an issue with delays in putting projects into production.
Generally Sammy Shop places the orders, but from time to time the least busy person in the shop will head to the local supplier to pick up raw materials inventory and bring them to the shop. The individual picking up the goods will identify themselves as a KMI employee and ask the supplier to charge the amount to KMI’s shop.
Purchase orders are used, but a review by Jerry and his team find that there are several supplier invoices where there is no purchase order, and Jerry has been unable to verify the numerical sequencing of the purchases orders as several seem to be missing. Further many purchase orders were signed by various different shop employees. This was concerning as Mr. Cutter had indicated that Sammy was the one responsible for purchasing.
KMI is currently using a periodic inventory system, but counts are done only sporadically.
KMI uses the supplier’s bill of lading as a receiving report, and does not prepare one themselves.
Invoices are sometimes attached to the bill of lading but are most often mailed to KMI by the suppliers head office. When invoices are attached to the bill of lading the invoice will be taken by one of the shop employees to the bookkeeper’s office.
There is no designated individual charged with receiving goods. Anyone who has a spare minute will help receive the delivery and stack the materials in a corner of the shop.
The bookkeeper will try to match the invoice with the purchase order before sending to Mr. Cutter for approval. However, as mentioned, there are occasions where the purchase order is not present. Mr. Cutter generally approves the invoice for entry and subsequent payment without asking for all of the necessary documents.
After approval from Mr. Cutter, the bookkeeper will enter the bill into the system and arrange to have the cheque prepared by the due date. Every Friday the bookkeeper prepares a cheque run for the bills that are due and brings the cheque to Mr. Cutter for signature. As he has gotten busier and busier, he had authorized the bookkeeper to sign cheques up to $5,000 without his signature.
With respect to new suppliers, Sammy Shop is authorized to purchase goods and approve new vendors where he sees fit—if he thinks it will be in the best interest of the company.
Any goods to be returned are piled by the back door for pick up by the supplier. On occasion the credit note is given directly to the shop personnel for delivery to the bookkeeper.
Sales and Collections Cycle
This process starts with the acceptance of orders from KMI’s customers—an ever growing list as Sam Slick is very aggressive in securing new business. Mr. Cutter is very pleased with the sales growth and intends to give Sam a good bonus if targets are met. Jerry has asked if Mr. Cutter if he approves new customers. The answer is no. He cares only about the sales.
Jerry on the other hand is somewhat concerned as he has seen the allowance for doubtful accounts grow disproportionally to the rate of sales growth.
Estimates will be prepared by Sam and Mr. Cutter and then sent to the customer for review and ultimate approval.
Upon approval an invoice is prepared for 10% of the value of the work and sent to the customer for payment. In addition, the estimate is given to Sammy Shop so that he may start to schedule and plan the work.
Upon completion of the project, Sammy will arrange for shipping and then tell the bookkeeper to invoice the customer for the balance of the work. Bill of ladings or other shipping documents are not prepared. Often the invoice is sent with the completed work.
Jerry has reviewed the process in the past and has found that while sales invoices are numbered, there have been occasions where he has found gaps in the numerical sequencing. When he has inquired as to why this might be, the bookkeeper and Sammy said that on occasion the invoice was wrong and had to be torn up.
Most customers pay by cheque or eft, but on occasion small project customers bring cash to the business. The receptionist will accept the cash and bring it to the bookkeeper. The receptionist will also forward any cheques received to the bookkeeper. Cash and cheques are kept in her desk in a locked drawer until she can get to the bank—usually once a week.
Sales returns are handled by the shop staff who receive the returned inventory and place it in the corner of the shop. Sam Slick will then try to resell this inventory if he can. Often these are the small cash sales mentioned above.
Sam will advise the bookkeeper of the return and ask her to prepare a credit note to send to the customer. Like the sales invoices the credit notes are pre numbered but Jerry has found gaps in the sequencing. He has received the same reply to his queries about missing credit notes: “We tore them up because some were wrong”.
Cash Controls
Most of the cash handling is described below with the exception of monthly bank recs. These are done by the bookkeeper but upon review by Jerry there have been a few instances where there have been “plug” entries in the general journal that have been done to balance the bank reconciliation.
Petty cash is kept by the receptionist who disperses as she sees fit to the various employees of the business. Most often there are receipts given to support expenditures, but not always. When the fund runs low she brings the receipts to the bookkeeper and asks for a cheque to replenish the fund. She will then go to the bank to get the cash.
Jerry has also noticed a few instances of cheques being issued to “Cash” and has also been told by Sammy that he has a few pre-signed blank cheques in his office in case he needs supplies quickly and Mr. Cutter or the bookkeeper are not available to sign cheques for C.O.D. delvieries.
Required
Working in teams you are to research internal controls over the purchases/payments and the sales/cash collections process and make recommendations on how Mr. Cutter might effectively implement a system of effective controls to protect assets and ensure efficient operations.
Your recommendations will take the form of a formal report to Jerry.
You must keep in mind that KMI is a small business and that a cost-benefit analysis must be undertaken before any controls can be implemented.
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