Question

New Phone Inc., a diversified manufacturer, has five divisions thatoperated throughout the United States and Costa Rico. New PhoneInc. has historically allowed its divisions to operateautonomously. Corporate intervention occurred only when plannedresults were not obtained. The corporation’s management has highintegrity, but the board of directors and audit committee are notvery active. New Phone Inc. has a policy of hiring competent andaggressive people. The company has a code of conduct, but there islittle monitoring of compliance employees. Management is somewhatconservative in terms of accounting principles and practices, butemployee compensation packages depend highly on performance. NewPhone Inc. does not have an internal audit department, and itrelies on your firm to review the controls in each division.
Cheryl Smith is the general manager of the Intercept Division. TheIntercept Division produces a variety of standardized parts forsmall smart phones. Smith has been the general manager for the lastseven years, and each year he has been able to improve theprofitability of the division. She is compensated based largely onthe divisions’ profitability. Much of the improvement inprofitability has come through aggressive cost cutting, including asubstantial reduction in control activities over inventory. Theperiodic FIFO method of accounting for inventory is used.
During the last year a new competitor, Deflector Inc., enteredIntercept’s markets and has offered substantial price reductions,intense marketing and friendly customer service in order to grabmarket share. Smith has responded to the competitor’s actions bymatching the price cuts and increasing customer service in the hopeof maintaining market share. Smith is very concerned because hecannot see any other areas where costs can be reduced so that thedivision’s growth and profitability can be maintained. Ifprofitability is not maintained, her salary and bonus will bereduced.
Smith has decided that one way to make the division more profitableis to manipulate inventory because it represents a large amount ofthe division’s balance sheet. She also knows that controls overinventory are week. She views this inventory manipulation as ashort-run solution to the profit decline due to the competitor’sprice cutting. Smith is certain that once the competitor stopscutting prices or goes bankrupt, the misstatements in inventory canbe corrected with little impact on the bottom line.
In your paper identify and evaluate the strengths and weaknesses ofNew Phone Inc.’s control environment. Write an auditor’s internalcontrol opinion report based upon the New Phone Inc.’s internalcontrols. Also, discuss the factors New Phone Inc.’s controlenvironment that have led to and facilitated Smith’s manipulationof inventory. Finally, discuss what controls should be put in placeto strengthen New Phone Inc.'s control environment.