INTERNAL AUDITING (FAA4004-E)

CASE STUDIES 01

Comstock Industries Issues

Mark Hobson, a CGA and CIA, is an internal auditor employed by Comstock Industries.
He is just completing an audit of the Avil Division conducted during the first five weeks
of the year. The Avil Division is one of three manufacturing divisions in Comstock and
manufactures inventories to supply about 50% of Comstock’s sales. In addition to the
manufacturing divisions, Comstock has two marketing divisions (domestic and
international) and a technical service division that offers world-wide technical support.
Each customer is assigned to the most suitable manufacturing division which functions as
the supplier for that customer. The manufacturing division then approves the customer’s
credit, ships against orders obtained by the sales representatives, and collects the
customer receivables when due. This allows order-to-order monitoring of customer credit
limits against customer orders received.
Findings
Two items that came to his attention during the audit concern Mark: There is a material
dollar amount of inventory of part number A2 that is still carried on the Avil books,
despite the fact that the Fast-tac machining component in which part A2 was used is now
considered first generation and is no longer manufactured. Company policy requires an
immediate write-off of all obsolete inventory items. Some accounts receivable still
carried as collectible were over 180 days old. All receivables are due in 30 days, which is
standard for the industry. Mark believes that many of these old accounts are
uncollectible. The division manager’s administrative assistant, Brenda Wilson, performed
the aging of accounts receivable, rather than the division accountant, as is standard
practice. (The division accountant refused to discuss the circumstances of Brenda’s
actions or either of the issues which arose during the audit.)
The auditee’s comments
Mark scheduled a meeting with Brenda and discussed the above concerns. “Well,
Mark,” Brenda responded, “I know that policy requires that obsolete inventories

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be written off, but that part A2 is just not being used at present. We might start to
make those Fast-tac components again. Who knows? Wide ties are coming back
again, aren’t they? Fast-tac could too. There are plenty of customers, especially in
developing nations, who are finding those newer generation machines pretty
expensive to maintain. I mean, there is a policy that states obsolete inventories
should be written off, but there is no policy defining an obsolete part. “And as for
those receivables,” Brenda continued, “that is certainly a judgment call, too. Who
knows if those receivables will be collected? We’re in a slight recession now.
When things pick up, we’ll probably collect a few. There isn’t even a policy in this
division on writing off receivables — I checked: nothing says I have to write them
off. So who are you to say I have to?” Mark argued: “Brenda, you know those
parts will never be used. And you know those receivables are bad.” “Look, Mark,”
Brenda finally bargained, “it’s only a few weeks from the close of the year. Let’s
leave these items as they are until after the close so that everyone gets their
bonuses. Then, I promise I’ll take a fresh look at both inventories and receivables.
I’ll write them down after year end, after the financial reports are issued. No one
will know. And, after all, who’s to be hurt?”

Mark continued his audit, drafted his report containing findings related to the
inventory and receivables, and reviewed the draft report with the division
manager, Hal Wright. Hal was visibly disturbed. “Gee, Mark, this couldn’t have
come at a more awkward time. Our figures just got audited by the external auditors
— there was a guy out here for our inventory count in November and Brenda sent
her aging of the year-end receivables to corporate headquarters. No one up there,
in our group or on the external audit team, was the least bit critical. If you go
raising problems particularly now, the external auditors will catch us writing off
inventory and receivables. They’ll adjust profit and there will be hell to pay, for all
of us. And, Mark, this is no clear-cut issue, either. I mean, I can see how you can
write a report calling for clearer policy, but never one calling for specific write-
downs. That’s way out of your jurisdiction. But still, I promise, we’ll look at all
this after our statements are accepted. Right now, I feel the managers of this
division have worked their hearts out and I intend to fight to protect what little
bonuses they have coming. If we write down as you suggest, those bonuses will go

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 and the stockholders will lose too. Earnings per share will drop like a rock. They
might even close this division. Now you don’t want that, do you?” “Well, Hal, I
could word my findings as they are in the draft but include your response….” Hal
was suddenly angry. “What? And let the audit committee decide the issue? They
have nothing to do with this. They accepted the external auditors’ report. If you
want to make the audit committee happy, you’ll accept it too and leave this
adjustment stuff alone.”

The internal audit director

Concerned, Mark delayed finalizing his report and discussed the draft with Gail Wu,
director of internal audit. Gail was not trained as an auditor and was promoted to director
of internal audit from the treasury division of corporate finance so that she might develop
a better understanding of operating relationships. Still, Gail is very smart and Mark has
always respected her opinion. The discussion was by telephone, with Mark still at the
Avil Division headquarters and Gail at the corporate office. “Mark, Hal is right. If you
blow the whistle on management bonuses this year, we can forget all the goodwill that
I’ve been struggling to build for our department. It will all go out the window.” Mark
responded, “I know you’ve been trying to put us on a better footing with management,
Gail, but Hal is intractable. As far as he is concerned, the only finding he will accept in
the report is that of deficient policy, with nothing mentioned about the inventory or
receivables needing adjusting.” “Well, do what you have to do,” Gail ended the
discussion. “But I insist that you submit a report that Hal agrees to and has signed. I don’t
want to upset anyone, then have to try to explain my report to the board when everyone is
complaining about the effect on the results and the bonuses.”

QUESTIONS
A. Refer to The IIA's Code of Ethics. Identify three specific Rules of Conduct relevant to
this case. Using the Rules of Conduct you identify the context, discuss the ethical issues
raised in the case.
B. Discuss how the ethical dilemma Mark faces might have been avoided. In other words,
discuss specific things Comstock's management and/or the internal audit function might
have done to reduce the risk of such a situation arising.

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C. Clearly indicate what you would do if you found yourself in Mark's position.