Scenario

Question

One of your friends has opened a new wholesale electronics business and wants your help figuring out some inventory issues they are facing.

One night last week, there seemed to be fewer HD televisions in the warehouse than they expected. The last time they were in the warehouse was a week earlier, and they hadn’t noticed anything amiss.

As they looked around, they saw that the evening warehouse worker was filling the last orders of the day. The delivery driver and day warehouse worker were gone for the day, and the delivery van keys were on the desk that the warehouse workers shared. The doors to the loading dock were open, as was the door to the office area where the accountant, two customer service specialists, and the owner worked.

Knowing that you are familiar with accounting principles, they asked for your help in figuring out how to prevent this in the future.

Prompt
Based on what you have learned about internal controls, provide recommendations on what controls the business owner should put in place to prevent loss of inventory and ensure that any losses are reported immediately. Also, specify which parts of the financial statements are affected by these losses.

Specifically, you must address the following rubric criteria:

Role of Internal Controls
Explain the role of internal controls in business settings. Also explain how not having internal controls in place may impact the accurate analysis of any wrongdoing.
Recommendations
Recommend at least two internal controls that should be put in place to prevent inventory from going “missing,” noting any assumptions you are making about the root cause of the missing products and how your recommendations will help address them.
Recommend at least one control that should be put in place to alert the owner if something is actually missing.
Financial Statements
If you found that two $400 HD televisions were missing, explain which financial statements you would correct and how. Be specific as to accounts and amounts.
Citations and Attributions
Support your response with cited sources using APA style.

Answer 1

Internal Controls in Business Settings

The primary role of internal controls in business settings is to safeguard assets, ensure the accuracy and reliability of financial reporting, promote operational efficiency, and foster compliance with applicable laws and regulations. Internal controls serve as a system of checks and measures designed to prevent errors and fraudulent activities, thereby limiting the risks associated with theft, loss, or misstatement of financial information.

Without effective internal controls, organizations may be vulnerable to theft, fraud, and operational inefficiencies. The absence of such controls can lead to inaccuracies in financial reporting and the inability to accurately identify and address instances of wrongdoing. For example, unmonitored access to inventory may lead to discrepancies between physical counts and recorded amounts, while the lack of segregation of duties could result in unauthorized transactions going unnoticed, compromising the integrity of the company's financial statements.

Recommendations for Internal Controls

1. Segregation of Duties: One crucial internal control to implement is the segregation of duties among employees responsible for inventory management. For instance, the roles of receiving inventory, maintaining inventory records, and authorizing the sale or use of inventory should be distributed among different individuals. This would limit the opportunity for any single employee to both perpetrate and conceal inventory theft. Assuming that the root cause of the missing products relates to inadequate checks on inventory handling, this recommendation enhances oversight and accountability.

2. Regular Inventory Audits: Another important internal control is to conduct regular physical inventory audits, compared with recorded amounts in the accounting system. Implementing routine counts—such as monthly or quarterly physical checks of inventory—allows the business to identify discrepancies sooner rather than later. This will help in recognizing whether there is a pattern of theft or loss, encouraging a proactive approach to addressing such issues.

3. Inventory Management System Alerts: Implementing an electronic inventory management system that sends alerts when inventory levels fall below a certain threshold or when discrepancies are detected can help the owner quickly identify missing items. The alerting system could be based on systematic scans of inventory data against predefined expectations, ensuring that the owner is notified immediately if something is missing or requires further investigation. This recommendation assumes that the absence of timely information contributes to prolonged undetected inventory loss.

Financial Statements Affected by Missing Inventory

If it is found that two HD televisions, valued at $400 each, are missing, the financial statements that need correction would include both the balance sheet and the income statement.

• Balance Sheet: The missing inventory of $800 (2 TVs x $400) needs to be deducted from the inventory asset account. The journal entry would be:

  • Debit "Cost of Goods Sold" $800
  • Credit "Inventory" $800 This adjustment decreases total assets on the balance sheet, accurately reflecting the company's current inventory levels.

• Income Statement: As a result of the missing inventory, the Cost of Goods Sold (COGS) will increase by $800, reflecting the loss and impacting the gross profit. Assuming other revenue conditions remain constant, the overall net income would decrease accordingly, leading to:

  • An increase in COGS of $800
  • A subsequent decrease in net income by the same amount

Thus, the integrity of financial statements is crucial for stakeholders’ decisions, and effective internal controls play a significant role in maintaining this integrity.

Citations For this response, while specific literature is not directly cited, resources on internal control principles, such as the COSO framework, are invaluable. For comprehensive familiarization, refer to:

• COSO. (2013). Internal Control - Integrated Framework: Executive Summary. Retrieved from https://www.coso.org/Pages/ic.aspx

Further information can be gleaned from accounting texts that discuss the importance of inventory management controls within an organizational context (e.g., Horngren, C., Sundem, G. & Stratton, W. 2013. Introduction to Management Accounting).