Question

During a review of a small business entity's internal control system, the auditor discovered that the accounts receivable clerk approves credit memos and has access to cash. Which of the following controls would be most effective in offsetting this weakness?

1) The owner reviews errors in billings to customers and postings to the subsidiary ledger.
2) A controller receives the monthly bank statement directly and reconciles the checking accounts.
3) The owner reviews credit memos before they are recorded.
4) The controller reconciles the total of the detailed accounts receivable accounts to the amount shown in the ledger.

Answer 1

The most effective control to offset the weakness of an accounts receivable clerk approving credit memos and having access to cash would be for the owner to review credit memos before they are recorded. This adds a layer of scrutiny and adheres to the principle of segregation of duties, which is crucial for internal control effectiveness.

Step-by-step explanation:

When reviewing a small business entity's internal control system, discovering that an accounts receivable clerk both approves credit memos and has access to cash reveals a significant control weakness. This presents a risk because the clerk has the ability to both generate credits and handle cash, thereby increasing the potential for fraud or errors that could harm the business's financial integrity. Segregation of duties is a key principle in internal controls designed to prevent such issues.

To address this weakness, the most effective control from the options provided would be for the owner to review credit memos before they are recorded (option 3). By doing so, the owner provides an additional layer of scrutiny to ensure that transactions are legitimate and approved at an appropriately high level of authority. This process helps to detect and prevent unauthorized credits that an employee with conflicting roles, such as cash access, might issue.

For Noel's situation, a similar principle applies. Their diligence in noticing a $250,000 error on an equipment bill and taking immediate action highlights the importance of attentive review processes. If such measures are systematically implemented as controls within a company, they can significantly reduce the risk of financial misstatements or fraudulent activity.