Question: Tina is an audit manager with a

Tina is an audit manager with a national public accounting firm and one of her clients is Simply Steam, Co. Simply Steam provides industrial and domestic carpet steam-cleaning services. This is the first time Simply Steam has been audited. Thus, Tina does not have any prior-year audit files to review. Tina recently conducted a preliminary interview with Doug Dosio, who along with his brother, Phil, owns Simply Steam. Tina’s objective for the interview was to establish an understanding of the control environment. To prepare for her interview, Tina reviewed professional auditing standards. Auditing standards indicate that the control environment sets the tone of an organization, influencing the control consciousness of its people. It is the foundation for all other components of internal control, providing discipline and structure. Control environment factors include the following:  Integrity and ethical values  Board of directors  Management’s philosophy and operating style  Organizational structure  Financial reporting competencies  Authority and responsibility  Human resources REQUIRED Using the interview dialogue on the pages that follow, you will be evaluating the seven components of the client’s control environment in order to make an evaluation of the overall internal control environment.To assist you in making this overall assessment, an evaluation form is provided after the interview dialogue and contains detailed descriptions of factors that may weaken or strengthen each of the seven components comprising the overall control environment. Before reading the interview information, please spend a couple of minutes reviewing the assessments you will make. After reading the dialogue, you will make the overall assessment labeled, “Overall Evaluation of the Control Environment.” Unless otherwise notified by your instructor, please rate the effect each of the seven components has on the control environment at Simply Steam. When making your judgments, please circle the appropriate number according to the scales provided. The case was prepared by Mark S. Beasley, Ph.D. and Frank A. Buckless, Ph.D. of North Carolina State University and Steven M. Glover, Ph.D. and Douglas F. Prawitt, Ph.D. of Brigham Young University, as a basis for class discussion. Simply Steam is a fictitious company. All characters and names represented are fictitious; any similarity to existing companies or persons is purely coincidental. INTERVIEW WITH CLIENT [TINA] Doug, can you give me a little information on the background of Simply Steam? [DOUG] Simply Steam provides both a domestic and industrial carpet steam-cleaning service and sells a relatively small amount of inventory, such as spot removers and carpet fresheners. Our company provides this service throughout three counties, which cover over 40 townships in a densely populated area. Simply Steam is completely owned by Phil and me. Our business has grown rapidly from one car-pulled trailer to 12 fully equipped vans, worth about $30,000 each, in less than six years. After the second van was purchased, we just figured the idea was to go “full steam ahead” by anticipating the continuing and, quite frankly, totally unexpected surge of business. We like the idea of purchasing a new van each year until we just can’t keep them all busy. The company grossed just over $1,650,000 in revenues last year, about half of which was collected in cash.We feel our continuing success is due in large part to “word of mouth.” [TINA] Can you tell me something about the day-to-day operations? [DOUG] Well, Mr. Day, our office manager, and I are in charge of a small sales force that goes out on leads to give estimates for new jobs. Mr. Day is paid a salary plus a percentage of the total sales each month. My brother, Phil, is usually out in the field managing the 20 employees who work as cleaners for Simply Steam. Phil is the only other person who helps me with managerial and operating decisions, and is in charge if Mr. Day or I are not available. Salespeople are paid on a commission basis, selling both the domestic and industrial jobs based on standard prices established by the owners. Salespeople may sometimes negotiate special cut rates during the slow spring and fall seasons. However, these are usually subject to approval by Mr. Day or me. Large industrial jobs are typically booked well in advance of the actual work. The job commitments obtained by the salespeople are normally submitted to Mr. Day, who signs them to indicate his approval and then returns them to the salespeople. Salespeople then forward job commitments to one of the two data input clerks for processing. The computer processes each commitment by extending the number of jobs by the standard price stored on the pricing file, or in specially negotiated situations, by the price on the input document. The sales, accounts receivable, and commitment files are updated and invoices are produced. An exception report of special prices is produced and sent to the salespeople to ensure that the specially negotiated commitments to jobs were processed correctly. Mr. Day pieced together this sales system himself, and so far it’s working fairly well. He hasn’t had a chance to finish a user manual for the system yet. I’ve also discovered that he sometimes alters the system. He says he does this to make the accounting process more efficient. I’ve told him to reevaluate the process at least once every couple of months. [TINA] And how about your accounting department? How big is it, and who oversees the accounting process? [DOUG] The accounting department of Simply Steam consists of seven part-time clerks, including the two data input clerks, who are all paid an hourly wage. None of our clerks has an accounting degree, but all, except one, are college students majoring in accounting. Mr. Day trains all new accounting help when they are first hired. They’re only with us a couple of years and generally leave as soon as they graduate. We keep them pretty busy around here, but despite the heavy workload, everyone helps each other when necessary and somehow the job always seems to get done. [TINA] What are your brother Phil’s responsibilities? [DOUG] Phil takes care of the cleaning end of the business. He usually trains all newly hired cleaning employees and explains what they need to know and how to do the job. When he feels the time is right, the new hire is teamed with a more experienced worker and assigned to a truck unit. When additional help is needed, Phil places ads in the local newspaper. Phil is pretty good at running that part of the business. [TINA] What about employee turnover? [DOUG] It happens all the time in this business, but Phil deals with it. We try to prevent any concerns or other problems with the help by having an open door policy so that if any of the employees have questions about what they are supposed to be doing they can let us know or ask for help without feeling awkward about it. If something comes up that affects everyone, Phil and I will bring the problem up at the next monthly office meeting to be certain everyone knows about it. Phil and I make sure the problem gets straightened out one way or the other. Doug leaves to give an estimate and Tina continues her observations of the business. Later that day, after spending time with the accounting staff, Tina has a moment to ask Mr. Day, the office manager, a few questions. [TINA] Mr. Day, I’m wondering if you could help me clarify some things regarding my brief observations of the accounting staff? [MR. DAY] Sure, I’d be glad to.What can I do for you? [TINA] I got the impression from the staff that they’re not always certain about their assigned functions. Are job responsibilities clearly defined? [MR. DAY] In assigning office responsibilities, Doug says that one of the main considerations is that the work should be done by the people who are available when it has to be done, assuming they’re familiar with a task and capable of doing it. This does lead to an overlap between one person’s job and another’s. But the actual assigning of daily duties and overview of each day’s accounting records are left to me and I don’t feel there’s any confusion. [TINA] The staff mentioned that they’ve occasionally had problems processing collections of trade receivables. Do you prelist cash receipts before they’re recorded? [MR. DAY] Well, actually we don’t. The way the system is set up, we collect all of the checks at the end of the day and record them all at one time, so we don’t need to write them down twice. Besides, we always find a way to resolve any collection processing problems that arise. [TINA] Do you ever run into accounting policy problems? [MR. DAY] Not very often. I usually handle any accounting policy problems that arise, although Doug will handle the situation if he feels strongly about the issue. [TINA] Well, thank you Mr. Day. I need to talk to Doug before he leaves for the day. A few moments later, in Doug’s office . . . [TINA] Are you satisfied with the processing of trade receivables? [DOUG] You don’t need to worry about that. Mr. Day prides himself on being meticulous in clerical operations, being well systematized and having excellent control over the trade receivables. Besides, the receivables are pledged as security for a continually renewable bank loan. The bank has been lending us money for the past year and a half based on a list of pledged receivables we furnish them each week. The loan is relatively small, and the contract allows the bank to access Simply Steam’s checking account if collection of the loan seems doubtful. Phil and I don’t know much about accounting and trust Mr. Day completely with all the accounting duties, but Phil and I are the only people allowed to sign company checks. [TINA] One of the accounting clerks mentioned that you’re thinking about making a change in the accounting system. [DOUG] As a matter of fact, Mr. Day has been looking into using a new accounting software package that should make the bookkeeping process an easier task for the clerks. This package will include a budgeting system that Mr. Day believes will help control costs and identify those areas that need attention. Up to now, I’ve always monitored the company’s expenses on an intuitive basis and I just never saw the need for a formal budget. If something didn’t seem right, Phil or I would bring the problem up at the informal monthly office meeting between all the employees to resolve the issue. Since our business has been getting bigger, maybe we’ll have to give in, spend the money and get some kind of sophisticated budgeting system. [TINA] I’m also interested in your security measures. How do you protect your accounting records and physical assets? [DOUG] After hours, the office door and windows are heavily bolted. All three of us—Phil, Mr. Day, and I— have keys to open the office. To tell you the truth, none of the file cabinets used to store the hard copies of the accounting records and data disks is locked up at night. We don’t have the computers bolted down to the desks, either. It’s occurred to us that maybe we should lock everything up, but we’ve never had any problems. As for the vans, they’re kept in a fenced-in lot behind our office. We give each driver a key to the gate lock so they can let themselves in or out for work. We have to do this because a lot of the commercial cleaning is done after hours, when the office is closed.To avoid any mischief, we change the lock every once in a while. [TINA] That should about do it for now, until I can get in to do some preliminary audit investigation. But before I leave, I’d like to ask you a few more general questions. To start with, can you tell me what you feel is responsible for Simply Steam’s recent success? [DOUG] Well, Tina, because Simply Steam is using the newest steam-cleaning procedure, we provide a much better result than the traditional rotary shampoo methods used by our competitors. And our customers can tell. Plus, Phil and I understand the business well, we are very personable and we pride ourselves on doing good work. [TINA] Having an audit performed by our firm is a big step.Why did you decide to have an audit now? Have you ever been audited before? [DOUG] Both Phil and I are excited about the success of our company because it will allow us to pursue other business endeavors in the future.We realize that the bigger the company grows and the better it looks, the more outside opportunities we will have. In order to meet this objective, we’ve asked your firm to not only provide an opinion on our financial statements, but also to make the financial statements take on a professional look putting us in the best light possible. We feel that audited financial statements will establish Simply Steam as a truly viable concern and lend credibility to the company with the local business and banking community. We’ve never been audited before, although we have used a local tax preparer to fill out our tax returns ever since Simply Steam has been in business. Incidentally, we did ask another firm, about two years ago, to come in to do an audit. But the audit never took place. Although I can’t remember the audit firm’s name, Phil and I just decided that Simply Steam could not afford the fees at that time. Hopefully, we’re ready for the audit now. [TINA] Are there any issues of concern that you have regarding the audit? [DOUG] Not really. I’m proud of Simply Steam. The company, to date, has had no record of fraud and has rarely had a problem with bad debts, since most of our receivable balances are collected within two to three weeks. [TINA] I understand that Simply Steam does not have an audit committee, which is typical of an organization this size. Can you tell me if Simply Steam has a board of directors and, if so, who serves on the board and how active the board is in overseeing important issues at Simply Steam? [DOUG] We do have a board of directors of sorts. It isn’t really all that formal, but Phil, I, and our wives function as directors.We do have at least one regularly scheduled meeting each year, and we have met on other occasions as necessary. Obviously, Phil and I have a pretty good idea of what is happening at Simply Steam on a daily basis. We don’t believe it makes sense at this point to try to include any outsiders on the board. Maybe we’ll do that in a couple of years, if we keep growing. [TINA] One final thing I’d like to ask—have you and your brother Phil set out any goals for the future? [DOUG] Well, although we’ve never actually written down any goals or objectives for Simply Steam, I do agree with Phil that future plans would include covering a larger sales territory, increasing advertising, investing in more help and additional equipment, and taking a well-deserved vacation in Hawaii. We’re not certain about our long-term goals, but the possibility of making a fortune and retiring early sounds pretty good.

1. Commitment to Integrity and Ethical Values 1 2 3 4 5 6 7 In evaluating this component, consider whether:  there appears to be sufficient integrity on the part of management and employees  management articulates ethical values to all levels of the organization, processes are in place to monitor adherence to ethical values, and deviations from ethical values are identified and addressed in an appropriate and timely manner 2. Board of Directors Demonstrates Independence and Appropriate Oversight 1 2 3 4 5 6 7 In evaluating this component, consider whether:  a board of directors and audit committee exists and is sufficient in membership to deal with important issues adequately  directors or audit committee members have sufficient knowledge, industry experience and time to serve effectively  some directors or audit committee members are independent of management  frequency and timeliness with which meetings are held with accounting officers and external auditors  the board oversees and takes action as needed  tone at the top is set by the board and management 3. Management’s Philosophy and Operating Style 1 2 3 4 5 6 7 In evaluating this component, consider whether:  business risks are adequately monitored  management is willing to undertake relatively low levels of business risk  management places a high priority on internal control  management explicitly attempts to reduce the risk of misstatements 4. Management Establishes Structure and Reporting Lines to Achieve Objectives In evaluating this component, consider whether:  the organization’s lines of authority and responsibility are clearly defined  operating policies are determined centrally by senior management  transaction policies and procedures are clearly established and strictly followed  the organization is adequately structured given its complexity and size  management is actively involved in the supervision of data processing  employee job responsibilities and specific duties are clearly established and communicated  job descriptions and organizational charts are maintained and periodically updated

5. Financial Reporting Competencies 1 2 3 4 5 6 7 In evaluating this component, consider whether:  management has specified the competence level needed for particular skills and translated the desired levels of competence into requisite knowledge and skills  evidence exists indicating that employees appear to have the requisite knowledge and skills  management provides training for employees to review and improve competencies 6. The Organization Holds Individuals Accountable for Their Internal Control Responsibilities 1 2 3 4 5 6 7 In evaluating this component, consider whether:  appropriate policies for acceptable business practices, conflicts of interest, and codes of conduct have been established and have been communicated to employees  individuals are evaluated and held accountable for their internal control responsibilities  Incentives, rewards and pressures are aligned with internal control goals and responsibilities  there is a clear assignment of responsibility and delegation of authority for goals and objectives, operating functions, and regulatory requirements  computer system documentation clearly indicates the procedures for authorizing transactions and for approving system changes  data processing policies and procedures are adequately documented 7. The Organization Demonstrates a Commitment to Attract, Develop, and Retain Competent 1 2 3 4 5 6 7 Individuals In evaluating this component, consider whether:  employees have the background and experience necessary for their job duties  employees understand the duties and procedures applicable to their jobs  the organization provides for adequate training of new personnel  the workloads of accounting personnel permit them to adequately control the quality of their work  the turnover rate of accounting personnel is low  the turnover rate of non-accounting personnel is low  organization maintains and periodically updates position descriptions as well as policies and procedures

Please list a few of the key pieces of information that influenced your decision: