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ABC Retailers Case— Internal Controls

ABC Retailers Inc. (ABC or the “Company”) is a U.S. public company that files
quarterly and annual reports with the Securities and Exchange Commission (SEC) with a
fiscal year end of August 31, 20X8. ABC is a leading retail chain operating more than
100 department stores across the continental United States. ABC department stores offer
customers a variety of nationally advertised products, including clothing, shoes, jewelry,
and other accessories. The Company’s supply chain of products is managed through a
single warehouse and distribution facility located in Kansas City, Missouri.

ABC has a centralized accounting and finance structure at its corporate headquarters,
where all processes and controls related to all substantive account balances occur. ABC
recognizes revenues from retail sales at the point of sale to its customers. Discounts
provided to customers by the Company at the point of sale, including discounts provided
in connection with loyalty cards, are recognized as a reduction in sales as the products are
sold. Cost of goods sold for the Company primarily consist of inbound freight and costs
relating to purchasing and receiving, inspection, depreciation, warehousing, internal
transfer, and other costs of distribution.

Case Facts

Audit Issue

On June 1, 20X8, the Accounts Payable (AP) Manager received an e-mail inquiry about
the process required for a vendor to change its bank account information. The e-mail was
sent from John Smith at a domain address listed as “Watch-Makers.” Watch Makers is a
manufacturer that supplies ABC-branded watches to ABC’s west region department
stores. In addition, John Smith is the primary contact at Watch Makers with whom the
Company typically interacts.

The AP Manager responded to the e-mail request on June 15, 20X8, with the procedures
required of the vendor, which include completing a vendor bank account request form.
On June 20, 20X8, the AP Manager received a reply e-mail from John Smith at “Watch-
Makers” with a completed vendor bank account request form, which included John
Smith’s signature, new bank account information, and other related information.

Upon receiving the vendor bank account request form, the AP Manager completed a
separately required Vendor Change Form for internal processing. The Vendor Change
Form is completed for new vendors or changes to existing vendors’ information,
including bank account information. The AP Manager sent the completed Vendor Change
Form to ABC’s Assistant Controller, who reviewed and approved the request on June 24,
20X8. The bank account information was updated within the Vendor Master File on June
26, 20X8.

Throughout the month of July 20X8, valid Watch Makers invoices were processed
through the Company’s accounts payable process, and the valid invoices were paid in
accordance with the Company’s processes for cash disbursements and wire transfers. On

Case 17-10: ABC Retailers – Internal Controls Page 2

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August 2, 20X8, the Company received an inquiry from Watch Makers about the
expected timing of the $2 million in outstanding invoices. As a result of the direct
interaction with Watch Makers’ employee John Smith, the Company determined that the
previous vendor bank account change form was received from a fraudulent domain name
with the intent to defraud the Company. The e-mail domain for Watch Makers is “Watch
Makers,” with no hyphen, rather than “Watch-Makers,” with a hyphen. Both e-mails
received from “Watch-Makers” were determined to be from a fraudulent source (that also
fraudulently used John Smith’s name in the e-mail). Because the bank account
information for Watch Makers was changed (as a result of the June 1, 20X8, e-mail
request) approximately $2 million in payments was wired to an incorrect bank account.

As noted above, there are two employees within the Company that were involved in
processing and approving the Vendor Change Form. The Company’s policy on bank
account change requests was put into effect and communicated by ABC’s Assistant
Controller in a September 1, 20X7 e-mail that indicated that for each Vendor Change
Form requesting a vendor bank account change, the accounts payable department was
required to (1) obtain a previously processed and paid invoice from the vendor requesting
the bank account change, (2) call the vendor using the contact information obtained from
the prior invoice, (3) verify the authenticity of the requested bank account change request
by directly contacting the vendor, and (4) include all relevant information obtained in
steps (1) through (3) as an attachment to the Vendor Change Form. The Company’s
control description relating to the review of a Vendor Change Form by the Assistant
Controller is not explicit regarding the specific attributes of the review. However,
because the policy was distributed by the Assistant Controller and the Assistant
Controller is also the control owner (e.g., performs the review), there is a presumption
that the Assistant Controller would understand that as part of her review, she should
evaluate whether the AP Manager obtained sufficient information to confirm the
authenticity of the bank account change request.

Other Relevant Facts

• Materiality — $8 million.
• The Company processed approximately 105 vendor requested bank account changes

during FY20X8 before the realization that the request from “Watch-Makers” was
fraudulent (from September 1, 20X7, to August 2, 20X8). After the identification of
the misappropriation of assets, the Company’s internal audit department obtained and
reviewed all 105 Vendor Change Forms reviewed by the Assistant Controller, noting
that only five Vendor Change Forms contained the information required by the
policy. In addition, internal audit determined that the primary review procedure
performed by the Assistant Controller related to the verification that the bank account
number was appropriately included on the Vendor Change Form. This procedure was
performed in all cases before the bank account information was input into the
accounts payable system.

• The total wire transfer payments made to the 105 vendors that requested bank account
changes in FY20X8 totaled approximately $56.2 million (based on an analysis
prepared by Internal Audit of the invoices processed and paid by the Company after
the processing of a Vendor Change Form for the 105 vendors).

Case 17-10: ABC Retailers – Internal Controls Page 3

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All Rights Reserved.

• There are more than 30 vendors with annual purchase activity of over $20 million (12
of which have purchase activity of over $40 million); thus, the amount of payments
made to any single vendor in a payables cycle could approximate $2 million,
assuming a cycle of 30 days.

• The Company’s Chief Security Officer completed an internal investigation and
concluded that there was no indication that the AP Manager and Assistant Controller
were involved in the scheme that resulted in the $2 million misappropriation.

• After the determination on August 2, 20X8, that the Vendor Change Form was from a
fraudulent source, the Company ceased processing additional Vendor Change Forms
until it could understand the root cause of the deficiency. On September 1, 20X8, the
Assistant Controller sent a reminder regarding the importance of following the vendor
bank account request change policy. The e-mail also highlighted an enhancement to
the process, which primarily included an enhancement to the Vendor Change Form.
The form was revised to include the following three new, explicit sections that are
required to be completed: (1) contact phone number pulled from previously processed
and paid vendor invoice, (2) name of individual at the vendor (from a previous
invoice) that was contacted, and (3) date discussed/contacted. The policy e-mail
reiterated the requirement to include a copy of the previously processed vendor
invoice with the Vendor Change Form.

• Internal Audit performed a thorough evaluation of the competency of the Assistant
Controller and concluded that notwithstanding the Assistant Controller’s lack of
historical performance, the Assistant Controller was suitably competent to perform
the control.

Engagement Team Note

In planning the FY20X8 audit, the engagement team obtained an understanding of the
internal controls related to cash disbursements. This understanding was developed
through the engagement team’s walkthrough of the cash disbursements process. As part
of its walkthrough procedures, the engagement team made inquiries of appropriate
personnel, inspected relevant documentation, and in certain cases, observed the control
performers carrying out required control procedures. As a result, the engagement team
concluded that there were no significant changes to the cash disbursements process in the
current year.

The engagement team identified three risks of material misstatement relating to the cash
disbursements process. For each risk identified, the team documented the control activity
that addresses the risk of material misstatement in the excerpted worksheet (see
Handout 1). As a result of the Audit Issue described above, the engagement team
identified a control deficiency in the following control:

CD5C — The Assistant Controller reviews each Vendor Change Form requesting a bank
account change, including the attached supporting documentation which includes the
following:

1. A previously processed and paid invoice from the vendor requesting the bank
account change.

Case 17-10: ABC Retailers – Internal Controls Page 4

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All Rights Reserved.

2. Details regarding a phone conversation with the vendor using the contact
information from the obtained invoice.

3. Verification of the authenticity of the requested bank account change request.

The Company’s control description regarding the Assistant Controller’s review of the
Vendor Change Form is not prescriptive regarding the specific attributes of the review.
However, there is a presumption that the Assistant Controller would understand the
primary objective of the control, which is to evaluate whether sufficient information was
obtained by the AP Manager to confirm that the bank account change request was
authentic.

Required:

1. What are the key considerations when evaluating the severity of a deficiency in a
control that directly addresses a risk of material misstatement?

2. Does the Assistant Controller’s failure to adequately review the Vendor Change
Form represent a deficiency in the design or operating effectiveness of the
control?

3. Is the failure in the vendor request change form control indicative of a material
weakness in internal control over financial reporting?

4. Would the deficiency warrant disclosure in the Company’s Form 10-K, Item 9A?
If so, what information would the Company be expected to disclose?

5. What implications does the deficiency have on other direct or indirect controls?