Read the following description of the Preview Company.

Preview Company Case Description

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Preview Company, a diversified manufacturer, has five divisions that operate throughout the United States and Mexico.  Preview has historically allowed its divisions to operate autonomously.  Corporate intervention occurred only when planned results were not obtained.  Corporate management has high integrity, but the board of directors and audit committee are not very active.  Preview has a policy of hiring competent people.  The company has a code of conduct, but there is little monitoring of compliance by employees.  Management is fairly conservative in terms of accounting principles and practices, but employee compensation packages depend highly on performance.  Preview Company does not have an internal audit department, and it relies on its external auditor to review the controls in each division.

Chip Harris is the general manager of the Fabricator Division.  The Fabricator Division produces a variety of standardized parts for small appliances.  Harris has been the general manager for the last seven years, and each year he has been able to improve the profitability of the division.  He is compensated based largely on the division’s profitability.  Much of the improvement in profitability has come through aggressive cost cutting, including a substantial reduction in control activities over inventory.

During the last year, a new competitor has entered Fabricator’s markets and has offered substantial price reductions in order to grab market share.  Harris has responded to the competitor’s actions by matching the price cuts in the hope of maintaining market share.  Harris is very concerned because he cannot see any other areas where costs can be reduced so that the division’s growth and profitability can be maintained.  If profitability is not maintained, his salary and bonus will be reduced.

Harris has decided that one way to make the division more profitable is to manipulate inventory because it represents a large amount of the division’s balance sheet.  He also knows that controls over inventory are weak.  He views this inventory manipulation as a short-run solution to the profit decline due to the competitor’s price-cutting.  Harris is certain that once the competitor stops cutting prices or goes bankrupt, the misstatements in inventory can be corrected with little impact on the bottom line.

a)              The following table includes two columns.  Include a brief phrase or sentence in the first column that merely describes the strength or weakness.  In in second column, explain why each strength is a strength or why each weakness is weakness.  In addition, for each weakness you identify, suggest an improvement that would reduce that weakness.  Finally, include issues that affect financial reporting and not operational effectiveness.  While the overall definition of internal controls includes operational effectiveness, auditors primarily are concerned about the accuracy of the financial statements.  I have included one example for each category to help illustrate what I am looking for in your answers.

Entity Level Controls
Strength Reason it is a strength
They hire competent people The key to any control environment is the quality of the personnel who carry out the control procedures.  Hiring competent people is the first step in insuring that the employees tasked with executing accounting functions as well as control activities will do a good job, which will reduce the risk of material misstatements.  However, it is only the first step in that competent employees also need the training and other resources, as well as an incentive, to perform their jobs well.  I listed this because the case mentions it.  I would need to verify that statement by actually reviewing the policies and procedures to confirm that it really is a strength.
Entity Level Controls
Weakness Reason it is a weakness  and suggested improvement
Divisions are autonomous The gives the division managers too much power, particularly because corporate management only intervenes if operating results are not met.  This gives managers more latitude to manipulate the accounting to keep within the corporation’s targets.  They should least establish period reviews of each division.  I would suggest quarterly, at least.

b)             What factors in Preview Company’s control environment led to and facilitated Harris’ manipulation of inventory?  Your answer here may include items you listed above, but you should relate the specifically to the inventory manipulation in the question.


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