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CHAPTER 7
Internal Control
Review Questions
7-1 Internal control is a process, affected by the entity's board of directors, management and other
personnel, designed to provide reasonable assurance regarding the achievement of objectives in the
categories of (1) operations, (2) reporting, and (3) compliance.
7-2 The five basic components of an organization's internal control are (1) control environment; (2) risk
assessment; (3) control activities; (4) (accounting) information and communication and (5)
monitoring.
7-3 The principles related to the control environment include commitment to integrity and ethical values;
board of directors independence and exercise of oversight; establishment of effective structure,
including reporting lines and appropriate authorities and responsibilities; commitment to attract,
develop, and retain competent employees; holding employees accountable for internal control
responsibilities.
7-4 Separating recordkeeping from custody of the related assets provides an independently maintained
record that may periodically be reconciled with assets on hand. This independent record holds the
personnel of a custodial department accountable for assets entrusted to their care. If the custodial
department maintained the accounting records, opportunity would exist for that department to conceal
its errors or shortages by manipulating the records.
7-5 Key factors in protecting a business against losses through embezzlement include adequate internal
control, fidelity bonds, and regular audits by independent public accountants.
7-6 The risk assessment component of internal control relates to the factors that affect the risk that the
organization’s reporting objectives will not be achieved. An awareness of this component contributes
to internal control because management's consideration of the possibility that reports (including
financial statements) may be misstated decreases the likelihood of misstatement.
7-7 The two types of monitoring are (1) ongoing monitoring activities, and (2) separate evaluations.
Examples of ongoing monitoring activities include continuous monitoring of customer complaints
Solutions Manual, Chapter 7, Page 1 of 20
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and reviewing the reasonableness of management reports. Separate evaluations include periodic
audits by the internal auditors.
7-8 The four types of control activities are (1) performance review, (2) transaction processing, (3)
physical controls and (4) segregation of duties. Performance reviews contribute to internal control
by providing management with an overall indication of whether personnel at various levels are
effectively pursuing the objectives of the organization. Transaction processing controls are performed
to check the completeness, validity, and authorization of transactions. Physical controls contribute by
assuring physical security over both records and other assets. Segregation of duties reduces the
opportunities for any one person to both perpetuate and conceal errors or irregularities.
7-9 Assuming that the general category of transaction has already been authorized by top management, at
least three employees or departments should usually participate in each transaction to achieve strong
internal control. One employee approves the transaction after determining that the details conform to
company policies, another employee records the transaction in the accounting records, and the third
employee executes the transaction by releasing and/or taking custody of the related assets. (Note: the
approval function may be omitted in an extremely simple transaction such as a cash sale not involving
a check).
7-10 The primary objective of the internal auditor is to aid corporate management in efficient
administration by investigating and reporting upon compliance with company policies, reliability of
accounting and statistical records and reports, adequacy of internal control, efficiency of operating
procedures, and effectiveness of performance in all areas of operation.
The primary objective of the external (independent) auditors is to determine whether the
financial statements fairly reflect the financial position, operating results, and cash flows of the
business. The external auditors have a responsibility to stockholders, creditors, and the public as well
as to management.
7-11 The external auditors should consider the work of the internal auditors as a portion of the control
environment of internal control. After evaluating the competence, objective, and disciplined
approach of the internal auditors, the external auditors will determine the extent to which the work of
the internal auditors may be used in determining the nature, timing, and extent of their testing.
7-12 Corporate governance is the system by which companies are directed and controlled. It includes the
policies, procedures and mechanism established to ensure that the company operates in the best
interests of its major stakeholders and society as a whole. The concept is broader than internal
control in that corporate governance is not only concerned with the effectiveness of financial
reporting, but it also encompasses ethical treatment of major stakeholders, compliance with laws,
regulations, customary business practices and effective risk management. The control environment of
internal control is particularly significant to corporate governance.
7-13 Auditors consider internal control because its quality has a major effect on the nature, timing, and
extent and nature of the audit procedures necessary to complete the audit. More specifically, the
auditors’ understanding of the entity and its environment, including internal control allows them to
(1) assess the risks of material misstatements of the financial statements and (2) design the nature,
timing and extent of further audit procedures.
7-14 If the safeguarding of company assets were the only objective of internal control, then some basis
might exist for the argument that the bonding of employees was an acceptable substitute for good
internal control practices. However, internal control has such other important objectives as assuring
the reliability of accounting data and other types of information needed by management for effective
direction of the business. When internal controls are weak or absent, the losses from waste and
inefficiency are apt to be far greater than losses from dishonest acts by employees.
An assessment of internal control by the auditors is a prerequisite to the determination of the
nature, timing, and extent of the further audit procedures necessary to express an opinion on the
financial statements. Under normal circumstances, the assessment of internal control significantly
reduces the cost of an audit, because a reduction in the assessed level of control risk permits the
auditors to perform much less substantive procedures than would otherwise be necessary.
7-15 Among the sources of information which auditors may use in preparing a working paper description
of internal control are: organization charts, charts of accounts, job descriptions, interviews and
discussions with officers and employees, reports of internal auditors, accounting reports and records,
inspection of facilities, and working papers and reports from prior examinations.
7-16 No. Designing audit plans involves complex judgments, resulting in the possibility of inconsistencies
in these judgments by auditors in the field. CPA firms attempt to reduce inconsistencies in judgments
by developing firm policies, and "decision aids" or guides, that assist auditors in gathering relevant
information or combining the information to make decisions about the nature, timing, and extent of
substantive procedures.
7-17 Tests of controls are efficient auditing procedures when the reduction in the substantive procedures
that results from a lower assessed level of control risk exceeds the amount of work involved in
performing the tests of controls.
7-18 Documentation is usually in the form of flowcharts, questionnaires, or written narratives of the
system.
7-19 During their consideration of internal control, the auditors will inevitably encounter some deficiencies
that should be brought to the attention of management. A management letter is the written report to
the client describing such deficiencies, along with the auditors' recommendations for corrective
action. This report serves as a useful reference document for management in implementing
improvements in internal control and may also serve to limit the auditors' liability to the client in the
event the control deficiencies subsequently give rise to defalcations or other losses.
7-20 The COSO Enterprise Risk Management Framework includes the following components:
(1) Internal environment—The internal environment encompasses the tone of the organization,
and sets the basis for how risk is viewed and addressed by the organization’s personnel.
(2) Objective setting—This activity involves setting the goals which should be aligned with the
organization’s mission. By setting objectives the organization can identify critical risk
factors that allow the organization to meet its objectives.
(3) Event identification—This activity involves identifying events that may be negative (risks),
positive (opportunities), or both. Events may result from external or internal factors.
(4) Risk assessment—This activity involves analyzing risks in terms of likelihood and impact.
(5) Risk response—This activity involves selecting the appropriate responses to the identified
risks. Responses may include avoidance, reduction, sharing, or acceptance.
(6) Control activities—Include the policies and procedures that ensure that the risk responses are
effectively carried out.
(7) Information and communication—Includes activities to ensure that relevant information is
identified, captured, and communicated to enable people to carry out their responsibilities.
(8) Monitoring—Involves management activities and separate evaluations designed to determine
whether needed modifications should be made to the enterprise risk management system.
7-21 You should explain to the president that auditing standards require the auditors to report significant
deficiencies and material weaknesses to the audit committee of the board of directors. Failure to
submit such a report to the board would be a violation of generally accepted auditing standards.
7-22 The two subsections of Section 404 of the Sarbanes-Oxley Act are 404a and 4040b. Section 404a
requires each annual report filed with the SEC to include a report in which management (1)
acknowledges its responsibility for establishing and maintaining adequate internal control over
financial reporting, and (2) provides an assessment of internal control effectiveness as of the end of
the most recent fiscal year.
Section 404b requires auditors of certain companies to attest to, and report on, internal
control over financial reporting.
7-23 The five stages of an audit of internal control performed in accordance with PCAOB requirements
are:
(1) Plan the engagement.
(2) Obtain an understanding of internal control over financial reporting (internal control).
(3) Test and evaluate design effectiveness of internal control.
(4) Test and evaluate operating effectiveness of internal control.
(5) Form an opinion on the effectiveness of internal control over financial reporting.
Questions Requiring Analysis
7-24 (a) (1) The effectiveness of internal control depends directly on the integrity and ethical
values of the personnel responsible for creating, administering, and monitoring
control of the organization.
(2) Control is more effective if the employees are competent in performing their duties.
(3) The board of directors oversees the quality of the organization's financial reporting,
and acts as a deterrent to management override of controls and management fraud.
To effectively exercise oversight, the board must be independent.
(b) Through risk assessment, management can determine when new controls are needed because
of changes in the organization’s operations or economic environment. This process includes
an assessment of financial reporting risk, which is the risk of presenting materially misstated
financial statements.
Among the factors that result in increased financial reporting risk are (only four
required)
• Changes in the organization’s regulatory or operating environment.
• Changes in personnel.
• Implementation of as a new or modified information system.
• Rapid growth of the organization.
• Changes in technology affecting production processes or information systems.
• Introduction of new lines of business, products, or processes.
• Corporate restructurings.
• Expansion or acquisition of foreign operations.
• Adoption of new accounting principles or changing accounting principles.
(c) The five major objectives of an accounting system include:

• Identify and record all valid transactions.
• Describe on a timely basis the transactions in sufficient detail to permit proper
classification of transactions for financial reporting.
• Measure the value of transactions in a manner that permits recording their proper
monetary value in the financial statements.
• Determine the time period in which transactions occurred to permit recording of
transactions in the proper accounting period.
• Properly present the transactions and related disclosures in the financial statements.
(d) (1) Performance reviews provide management with an overall indication of whether
personnel at various levels are effectively pursuing the objectives of the organization.
(2) Transaction processing controls are designed to check the completeness, validity and
authorization of transactions.
(e) The two types of monitoring activities are (1) ongoing monitoring activities and (2) separate
evaluations. Ongoing monitoring activities include regularly performed supervisory and
management activities, such as continuous monitoring of customer complaints, or reviewing
the reasonableness of management reports. Separate evaluations are monitoring activities
that are performed on a nonroutine basis, such as periodic audits by the internal auditors.
7-25 (a) Internal control is defined as a process, effected by the entity’s board of directors,
management, and other personnel, designed to provide reasonable assurance regarding the
achievement of objective regarding (1) reporting, (2) operations, and (3) compliance.
(b) The definition includes the following concepts:

(1) Internal control is as a process—as a means to an end.
(2) The process is effected by individuals not merely policy manuals, documents, and
forms.
(3) Internal control can only provide reasonable assurance, which means that the cost of
internal control should not exceed the benefits derived.
(4) Internal control is designed to achieve objectives in the three areas of reliable internal
and external reporting, effectiveness and efficiency of operations, and compliance
with laws and regulations.
(c) The five components of internal control include:

(1) The control environment.
(2) Risk assessment.
(3) The accounting information and communication system.
(4) Control activities.
(5) Monitoring.
(d) The major limitations of internal control include:

(1) Errors in decisions may occur in designing, maintaining, or monitoring controls.
(2) Mistakes may be made in the performance of controls as a result of misunderstanding
of instructions, mistakes of judgments, carelessness, distraction, or fatigue.
(3) Top management can override internal control.
(4) Control activities dependent upon separation of duties may be circumvented by
collusion among employees.
(5) Design of controls is subject to cost-benefit considerations.
7-26 (a) The planned assessed level of control risk is the level the auditors intend to use in
performing the audit for as a particular financial statement assertion. For example, after
obtaining the understanding of internal control, the auditors will determine a planned assessed
level of control risk based on their understanding of internal control and risk assessment
procedures. The revised assessed level of control risk is the level of risk based on the
additional tests of controls performed to evaluate control risk for an assertion. Control risk is
the actual, but unknown, level of risk pertaining to an assertion.
(b) While obtaining an understanding of internal control, the auditors may determine a planned
assessed level of control risk for the existence of accounts receivable which requires them to
test as a sample of sales transactions. Based on the results of the tests of controls for sales,
the auditors may arrive at an revised assessed level of control risk that is either higher or
lower than the level planned. The actual level of control risk for existence of receivables is,
as always, at an unknown level.
7-27 (a) After or during obtaining an understanding of the client and its environment, including
internal control, the auditors perform their risk assessment procedures. Then they document
this understanding and the risk assessment procedures. At this point they may or may not
have performed some tests of controls as a part of the risk assessment procedures. When they
believe that a lower level of assessed control risk may be possible, and that the related
reduction of substantive procedures may be cost justified, the auditors will assess risk based
on the assumption that these controls are operating effectively. They will then design further
audit procedures, including tests of controls and substantive tests. Finally, when the
additional tests of controls and substantive tests have been performed, the auditors will
evaluate whether risk has been appropriately restricted.
(b) Obtain an understanding Inquire of client personnel.

Inspect various documents and records.
Observe control activities and operations.
Perform walk-through of transactions.
Perform some tests of controls.
Document the understanding Prepare flowchart.

Prepare checklists.
Prepare questionnaires.
Assess the risks of material Evaluate risk based on the understanding.

Misstatement (develop planned
assessed level of control risk)
Design and perform further Analyze information obtained above.

audit procedures (tests of Perform inquiry procedures.
controls and substantive Inspect documents for performance.
procedures Observe application of procedures.
Reperform application of procedures.
Perform substantive procedures.
Reassess control risk Analyze results obtained.
(or the risk of material
misstatement) and modify
substantive procedures)
Document the results of the risk Overall responses to risks.

assessment process Nature, timing and extent of procedures.
The linkage of procedures to assertion-level
Risks.
The results of audit procedures.
The conclusions regarding the use of
evidence about the operating effectiveness
of controls obtained in prior periods.
7-28 Since Bailey's consideration of internal control shows that controls are very weak, he may omit
performing tests of controls. He must, however, have an adequate understanding of internal control
to assess the risks of material misstatement. At a minimum, Bailey should obtain a basic
understanding of the control environment, risk assessment, information and communication,
monitoring, and important control activities. He should document this understanding, and also
document that control risk is assessed at the maximum level.
7-29 (a) (1) The primary advantage of the internal control questionnaire is that control
weaknesses, including the absence of controls, are prominently identified by the "no"
answers. Another advantage of the questionnaire is its simplicity. If the questions
have been predetermined, as is usual, the auditors' responsibility includes the
completion of the questionnaire with yes-or-no answers, and written explanations are
required only for the "no" or unfavorable answers. Also, the comprehensive list of
questions provides assurance of complete coverage of significant control areas.
(2) An advantage of the written narrative approach in reviewing internal control is that
the description is designed to explain the precise controls applicable to each
examination. In this sense, the working paper description is tailor-made for each
engagement and thus offers flexibility in its design and application. A second
advantage is that its preparation normally requires a penetrating analysis of the
client's system. In requiring a written description of the flow of transactions, records
maintained, and the division of responsibilities, the memorandum method minimizes
the tendency to perform a perfunctory review.
(3) The use of a flowchart in documenting internal control offers the advantage of a
graphic presentation of a system or a series of sequential processes. It shows the
steps required and the flow of forms or other documents from person to person in
carrying out the function depicted. Thus, the tendency to overlook the controls
existing between functions or departments is minimized. Another advantage is that
the flowchart method avoids the detailed study of written descriptions of procedures
without sacrificing the CPAs' ability to appraise the effectiveness of controls under
review. An experienced auditor can gain a working understanding of the system
much more readily by reviewing a flowchart than by reading questionnaires or
lengthy narratives. Information about specific procedures, documents, and
accounting records can also be located more quickly in a flowchart. Because of these
advantages, flowcharting has become the most widely used method of describing
internal control in audit working papers.
(b) Even though internal control appears to be strong, the auditors are required to conduct tests of
controls. Just because controls are prescribed does not mean that the client's personnel are
adhering to those requirements. Employees may not understand their assigned duties, or may
perform those duties in a careless manner, or other factors may cause the controls actually in
place to differ from those prescribed.
Through tests of controls the CPAs obtain reasonable assurance that controls are in use
and are operating as planned, and they may detect material errors of types not susceptible to
effective internal control. In addition, such testing enables the CPAs to comply with the third
standard of field work that calls for obtaining sufficient competent evidential matter to
provide a reasonable basis for an opinion.
Note to instructor—Auditors may forego tests of controls if they conclude that controls are so
weak as to provide no basis for assessing control risk at a level lower than the maximum.
7-30 (a) The following categories of measures and underlying measures are included in the AICPA
document on Antifraud Programs and Control Measures:
1. Create and maintain a culture of honesty and high ethics

▪ Set tone at the top
▪ Create a positive workplace environment
▪ Hire and promote appropriate employees
▪ Properly train employees
▪ Discipline
2. Evaluate the risks of fraud and implement processes, procedures, and controls to mitigate
those risks
▪ Identify and measure fraud risks
▪ Mitigate fraud risks
▪ Implement and monitor controls and other measures
3. Develop an appropriate oversight process
(b) Examples of measures that create a positive workplace environment include (only two
required):
▪ Encourage and empower employees to help create a positive workplace
▪ Allow employees to participate in developing and updating the code of conduct
▪ Encourage employees and give them the means to communicate concerns about potential
violations of the code of conduct without fear of retribution
Examples of factors that detract from a positive workplace environment include (only two
required):
▪ Top management that does not seem to care about or reward appropriate behavior
▪ Negative feedback and lack of recognition for job performance
▪ Perceived inequities in the organization
▪ Autocratic rather than participate management
▪ Low organizational loyalty or feelings of ownership
▪ Unreasonable budget expectations or other financial targets
▪ Fear of delivering “bad news” to supervisors and/or management
▪ Less then competitive compensation
▪ Poor training and promotion opportunities
▪ Lack of clear organizational responsibilities
▪ Poor communication practices or methods within the organization
7-31 The required documentation related to internal control in a financial statement audit include:
(1) Documentation of understanding of internal control (flowcharts, written narratives,
questionnaires, etc.).
(2) The overall responses to address the risks of material misstatement at the financial statement
level.
(3) The nature, timing, and extent of further audit procedures (including additional tests of controls
and substantive procedures).
(4) The linkage of further audit procedures with assessed risks at the relevant assertion level.
(5) The results of audit procedures (including tests of controls).
(6) The conclusions reached with regard to the use of the current audit evidence about the operating
effectiveness of controls that was obtained in prior audits.
7-32 The client's plan of organization is entirely unsatisfactory from the standpoint of establishing internal
control. He has ignored the basic control principle that two or more employees should participate in
every transaction. When one person has complete control over a certain type of transaction or a
certain phase of operations, it is usually possible for the individual to conceal any accidental errors or
wasteful acts as well as to cover up any fraudulent activities.
Placing the functions of purchasing, receiving, and storing of goods under one employee
would enable that employee to conceal inefficiency and losses from such causes as duplicate orders,
shortages in quantities received, excessive stockpiling, and "kickbacks" from suppliers.
The employee who has been given full responsibility for accounts receivable records and for
collections from customers would be able to abstract cash receipts and to conceal this theft by
falsification of customers' accounts.
The employee responsible for all aspects of the payroll could overstate the amounts owing to
employees or place fictitious names on the payroll.
Cash handling should be separated from recordkeeping. Duties should be divided so that the
work of one employee serves as proof of the accuracy of the work of other employees.
7-33 (a) (1) The primary auditing objective of the external auditors is to obtain sufficient
appropriate evidence to express an opinion as to the fairness of the financial
statements in accordance with generally accepted accounting principles. A secondary
objective is to determine that the client recognizes the objectives (listed below) of the
internal auditors and that suitable progress is being made toward their achievement.
The overall auditing objective of the internal auditors is to assist management in
achieving the most efficient administration of the operations of organization. This
total objective entails the protection of the interests of the organization, including
pointing out existing deficiencies to provide a basis for appropriate corrective action,
and the furtherance of the interests of the organization, including the
recommendation of changes for the improvement of the various phases of the
operations. The internal auditors are also a monitoring control that serves as the eyes
and ears of the audit committee of the board of directors. They help assure that
management does not override other internal controls.
(2) In conducting audits, internal auditors appraise company policies, organization,

records, and performance, whereas external auditors are essentially concerned with
the verification of data affecting the financial statements. Internal auditors are
charged with the responsibility of seeing that company accounting policies are being
followed; they are vitally interested in the cost of prescribed procedures and their
effect upon customers and company personnel. By reason of the nature of their
work, internal auditors undertake more exhaustive detailed inquiries than do the
outside auditors.
For audit purposes, external auditors are interested primarily in the end result of
the accounting processes but internal auditors are interested in the processes
themselves. CPAs propose correction of misstatements disclosed by their audits,
whereas internal auditors try to prevent occurrence or recurrence of misstatements.
Both auditors are concerned with the verification of the accuracy of the accounting
records. Because they must form an opinion on the company's financial statements,
external auditors are primarily concerned that the statements follow generally accepted
accounting principles. Internal auditors are aware of this aspect of auditing managerial
decisions, but principally concern themselves with determining that the decisions
promote administrative efficiency and have been compiled with.
(b) The external auditors may use the work of the internal auditors in obtaining audit evidence, or
they may use the internal auditors to provide direct assistance under direction, supervision,
and review of the external auditors.
7-34 The weaknesses and suggested improvements are as follows:
Weakness Suggested Improvement

1. The audit committee is not made up of all The audit should be made up of only outside
outside directors. Howard Kress, the chief members of the board of directors. That is,
financial officer, is a member. directors who are not officers or employees of
the company.
2. Howard Kress, the chief financial officer, The audit committee or the complete board of
reviews and approves related party directors should review and approve related
transactions. party transactions.
3. The internal auditor reports to Laura Howe, The internal auditor should report to the audit
the chief operating officer. committee of the board of directors to help
ensure objectivity.
4. While the company has a written code of The code of conduct should be distributed at
conduct, employees are only exposed to it least annually and employees should be
upon employment. required to recommit to adherence to the code
at that time.
5. The hotline for reporting unethical The hotline should be staffed by an objective
behavior is staffed by the corporate function, such as internal auditing.
controller.
Objective Questions
7-35 Multiple Choice Questions
(a) (2) Detecting management fraud is generally not considered to be an objective of internal
control. In fact, one of the inherent limitations of internal control is that it is subject
to override by management. All of the other answers represent valid objectives of
internal control.
(b) (4) Management review of weekly performance reports is an ongoing monitoring activity
that may detect errors or fraud. Answer (1) is incorrect because while periodic audits
by internal audit represent a monitoring activity, they best classified as separate
evaluations, and not ongoing monitoring activities. Answer (2) is incorrect because
the audit of the annual financial statements is the function of the external auditors.
Answer (3) is incorrect because approvals of cash disbursements represent a control
activity.
(c) (1) Because the auditors’ purposes are for considering internal control are to obtain the
necessary knowledge to (a) assess the risks of material misstatement, and (b) to
determine the nature, timing, and extent of the tests to be performed, answer (1) is
correct.
(d) (3) An increase in the substantive procedures will decrease detection risk, and thereby
compensate for the increased level of control risk due to a weakness in internal
control. Answer (1) is incorrect because if the weakness exists, increasing the extent
of tests will only provide more evidence on the weakness—not evidence that
compensates for the weakness. Answers (2) and (4) are incorrect because a decrease
in detection risk or inherent risk, not an increase, would compensate. Also, in the
case of inherent risk, it may not be possible to change the assessment since it is a
function of the firm’s environment.
(e) (3) Preparing bank reconciliations will detect a variety of misstatements related to cash
and is a detective control in the sense that it does not prevent the misstatement from
occurring, but may detect it. Answers (1) and (2) are incorrect because segregating
duties and requiring approvals are primarily designed to prevent misstatements.
Answer (4) is incorrect because the primary purpose of keeping backup copies of key
transactions (or all transactions) is prevent loss of information in the event of an
information system failure.
(f) (4) The symbol on the left indicates a manual function; the symbol on the right
represents a file.
(g) (1) The internal auditors' objectivity refers to their relative independence from the
organizational units they have been evaluating. This may best be determined by
considering the organizational level to which the internal auditors report. The other
answers address the issues of the internal auditors' competence, not objectivity.
(h) (2) Involvement of the owner in key control functions should be a major step toward
preventing material errors or defalcations. Answer (1) would not be cost-effective.
Answer (3) would provide some measure of control, but not as much as would daily
participation by the owner. If it were feasible to hire additional employees, it would
be cheaper to hire permanent employees rather than temporary. The need for internal
control is permanent. Answer (4) would weaken, not strengthen internal control.
(i) (3) An enterprise risk management system cannot eliminate all risks.
(j) (2) A confirmation is designed to obtain evidence from a third-party. It is not used to
document internal control.
(k) (1) Management may issue a report on internal control regardless of whether the system
has a material weakness.
(l) (3) In an audit of internal control performed under PCAOB standards the auditors must
test controls for all significant accounts.
7-36 The types of controls are as follow:
(a) D. The annual physical inventory is a detective control because it would serve to detect
misstatements of inventory after they have occurred.
(b) D. The monthly reconciliation of bank accounts is a detective control because it would
serve to detect misstatements of cash after they have occurred.
(c) P. Segregation of duties over purchasing would serve to prevent errors and fraud
relating to purchase transactions. Segregation of duties prevents individuals from
perpetrating errors and fraud and covering them up in the course of performing their
assigned duties.
(d) P. Supervisory approval of time cards is a preventative control because it would serve to
prevent errors and fraud with respect to payroll transactions. The supervisor approval
would help to prevent errors or fraud in the time records.
(e) P. Requiring dual signatures for checks is a preventative control because it would serve
to prevent errors and fraud with respect to cash disbursements.
(f) C. Adjustments of perpetual inventory records to physical counts would serve to correct
the inventory records.
(g) D. Management review of budget versus actual performance would serve to highlight
potential errors and fraud after they have occurred. Therefore, it is a detective
control.
(h) D. Internal audits of payroll would serve to detect errors and fraud in payroll after they
have occurred. Therefore, it is a detective control.
7-37 (1) Monitoring—ongoing.

(2) Control environment—commitment to attract, develop and retain competent employees.
(3) Control activities—transaction processing (or application) control.
(4) Risk assessment.
(5) Monitoring—separate evaluations.
(6) Control environment—integrity and ethical values.
(7) Control activities—performance reviews.
(8) Accounting information and communication system.
(9) Control activities—physical controls.
(10) Control environment—effective structure, reporting lines, and authority and responsibility.
7-38 Definitions
1. c 6. c
2. c 7. d
3. d 8. e
4. g 9. f
5. h 10. i
7-39 Definitions
(a) 3
(b) 2
(c) 1
(d) 7
(e) 5
(f) 11
(g) 10
7-40 Multiple Choice Questions
(a) (2) Auditors are not in general concerned with how controls originated.
(b) (3) While tests of controls involve, inquiry, inspection, observation and
reperformance, “observation of confirmations” doesn’t have a clear meaning.
(c) (4) Tests of controls address operating effectiveness of controls.
(d) (2) The planned assessed level of control risk is determined during planning.
(e) (3) The auditors never know the exact control risk involved—they always simply
have an estimate of it.
Problems
7-41 SOLUTION: Orange Corporation (Estimated time: 25 minutes)
ORANGE CORPORATION
Raw Materials Recording and Transferring System Flowchart
December 31, 20__
7-42 SOLUTION: Island Trading Co. (Estimated time: 25 minutes)
(a) Undesirable combinations are as follows:
(1) Cash receipts and accounts receivable

(2) Cash receipts and credit memos on sales returns and allowances
(3) Cash disbursements and accounts payable.
(4) Cash receipts and bank reconciliation
(5) Cash disbursements and bank reconciliation
(6) General ledger and cash receipts
(7) Accounts receivable and credit memos on sales returns and allowances
(b) Assignment of functions
Employee No. 1:
(1) Maintain general ledger

(5) Issue credit memos on sales returns and allowances
(6) Reconcile bank account
Employee No. 2:
(4) Maintain cash disbursements journal and prepare checks for signature
(7) Handle and deposit cash receipts
Employee No. 3:
(2) Maintain accounts payable ledger

(3) Maintain accounts receivable ledger
7-43 SOLUTION: Prospect Corporation Inc. (Estimated time: 55 minutes)
(a) PROSPECT CORPORATION INC.

Sales System Flowchart
December 31, 20__
(b) PROSPECT CORPORATION INC.
Cash Receipts System Flowchart
December 31, 20__
7-44 SOLUTION: Church Cash Receipts (Estimated time: 30 minutes)
Part (a)
Weakness Recommended Improvement

1. Financial secretary exercises too much To extent possible, finance secretary’s
control over collections. responsibilities should be confined to
recordkeeping.
2. Finance committee is not exercising its Finance committee should assume a more
assigned responsibility for collections. active supervisory role.
3. The internal auditing function has been An audit committee should be appointed to
assigned to the finance committee, which perform periodic internal auditing procedures
also has responsibility for the or outside auditors should be engaged.
administration of the cash function. Also,
the finance committee has not performed
the internal auditing function.
4. The head usher has sole access to cash The number of cash counters should be
during the period of the count. One person increased to at least two, and cash should
should not be left alone with the cash until remain under joint control until counted and
the amount has been recorded or control recorded.
established in some other way.
5. The collection is vulnerable to robbery The collection should be deposited in the
while it is being counted and from the bank’s night depository immediately after the
church safe prior to its deposit in the bank. count. Physical safeguards, such as locking
and bolting the door during the period of the
count should be instituted. Increasing the
number of cash counters will also reduce
vulnerability to robbery.
6. The head usher’s count lack usefulness The finance secretary should receive a copy of
from a control standpoint because he or she the collection report for posting to the finance
surrenders custody of both the cash and the records. The head usher should maintain a
record of the count. copy of the report for use by the audit
committee.
7. Contributions are not deposited intact Contributions should be deposited intact daily.
daily. There is no assurance that amounts If it is considered necessary for the financial
withheld by the finance secretary for secretary to make cash expenditures, he or she
expenditure will be properly accounted for. should be provided with a cash working fund.
The fund should be replenished by check
based upon a properly approved
reimbursement request and satisfactory
support.
8. No mention is made of bonding. Key employees and members involved in
receiving and disbursing cash should b
bonded.
9. Written instructions for handling cash Particularly because much of the work
collections apparently have not been involved in cash collections is performed by
prepared. unpaid, untrained church members, often on a
short-term basis, detailed instructions should
be written.
Part (b)
Weakness Recommended Improvement

1. The envelope system has not been The envelope system should be encouraged.
encouraged. Control features that it could Donors should indicate on the outside of each
provide have been ignored. envelope the amount contributed. Envelope
contributions should be reported separately
and supported by the empty collection
envelopes. Prenumbered envelopes will
permit ready identification of the donor by
authorized persons without general loss of
confidentiality.
2. The church maintains no permanent record A member’s contribution record should be
of amounts pledged and contributed. prepared by the financial secretary from the
These records are needed to (1) provide pledge cards and collection envelopes.
valid support for tax deductibility of
members’ contributions, (2) permit better
planning for fund drives, and (3) provide a
basis for direct confirmation of amounts
contributed.
3. No investigation is made of differences All members should be furnished with
between the amounts pledged and periodic written advice of the amounts
contributed. pledged and contributed. If properly handled
by the audit committee, this procedure can be
combined with direct confirmation of the
amount contributed. Not only will control be
better, but also members more likely will
fulfill their pledges.
4. Letters certifying to amounts contributed The maintenance of members’ contribution
are being furnished to members based record and the furnishing of periodic advices
upon the amounts shown on pledge cares. to members will correct this weakness.
This is improper because actual
contributions may not equal pledges.
5. No provision is made for the receipt f A church employee other than the financial
contributions by mail. This method of secretary should open mail. This employee
giving should be encouraged, but the should list the receipts, maintain a copy of this
financial secretary should not handle mail listing, and deposit the receipts. Checks
receipts. should be stamped with the restrictive
endorsement when received.
In-Class Team Case
7-45 SOLUTION: Willington, CPA (Estimated Time--50 minutes)
Case A—Controls appear strong; Auditor Case B— Case C—

decides to test controls to extent possible* Controls Controls
appear appear
strong, but weak*
auditor does
not test*
1. At what level is
planned assessed level
of control risk? (low; Low Maximum Maximum
moderate; maximum)
2. Describe the scope of

tests of control that will
be performed. (none; Tests performed None None
tests performed)
Results of Tests of Controls A(1)-- A(2)Controls A(3)

Controls moderately Controls N/A N/A
strong effectively ineffective
(operated
effectively)
3. At what level is the
assessed level of control
risk? (low; moderate; Low Moderate Maximum Maximum Maximum
maximum)
4. (a) What is the

acceptable level of
detection risk? (lowest; Moderate Low Lowest Lowest Lowest
low; moderate; high;
highest)
5. (b) Describe the scope

(nature, timing, and
extent) of substantive Moderate High Scope Highest Highest Highest
tests. (highest; high; Scope Scope Scope Scope
moderate; low; lowest)
*Inherent risk is assessed at the maximum level; evaluation of controls is based on management's description.
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her question the security she felt in my hands. In all sorts of weather,
under sail or steam, she had carried me clear of every pursuing ship
that challenged her speed. However rough the usage she never
rebelled or complained; wherever I directed her she went as true and
straight as an arrow, with never a misstep or a falter. If she had been
disgraced it was because I had elected to dishonor her; no part of
the blame was hers. She was not an inanimate, unfeeling thing
conceived by man out of iron and steel, but a living, breathing,
human creation, with all the passion and sympathy and devotion of a
woman, and, as is the way of most mortals, I did not know my own
love for her until I was about to lose her. I am not much given to
weeping, but there were tears in my eyes as I gave the signal that
stilled forever the steady pulsations of her great, true heart, and I
could feel the death tremor running through her as she came to a
stop.
While a royal salute boomed from her yacht’s gun forward I read
over her the burial service at sea prescribed by the Church of
England. Her own flag was sent to the maintop and the rest of her
bunting was astream from stern to bowsprit, over the mastheads.
Then, with the small boats forming a cortege alongside, we opened
her seacocks, pulled a short distance away, and watched her slowly
sink to her grave, tenderly lowered by her own mother, the sea. We
had taken our revolvers along for that particular purpose, our
protection being a secondary consideration, and as the waves that
her broken heart had warmed caressed the topmost flag we fired
another salute in her honor, as the final tribute of a love that, long
smouldering and not understood, had been fanned into full flame by
her burial, and she was gone. I owned many ships after that but
never one among them was I so sure of, under all conditions, as I
was of her.
The ocean whispered to itself of her brave deeds as it closed in over
her and we hoisted rags of sails on our three boats and headed for
Aden, where we landed late in the afternoon with a carefully
prepared story of the sinking of an imaginary ship. Aden was a port
of call for ships running out East and we took the next one that came
in for England.
We reached London early in 1877 where I learned with delight that
war between Russia and Turkey was imminent. The first thing I did
was to dissolve my partnership with Norton. While I had greatly
enjoyed the adventures that were a part of it, I did not relish the
business to which he had introduced me. I do not seek to avoid any
responsibility for my own acts; I went into the business with my eyes
open but it was not exactly the sort of thing I was cut out for, and it
left a bad taste in my mouth. Moreover, I preferred to operate alone.
Norton joined his wife, who was living in Devonshire, and I went to
the Langham Hotel, where I put myself in touch with my old agents
and other dealers in contraband, for I hoped the coming war would
produce some legitimate business. I was not disappointed, for very
soon I was asked to meet the diplomatic agent of Montenegro, a little
principality lying on the Adriatic between Turkey and Austria-
Hungary, which was at that time subject to the Sublime Porte. It was
cut off from the sea by a narrow military strip which was occupied by
Austria. Cattaro, the natural seaport of Montenegro, was within this
strip and was guarded by Austrian soldiers. The Montenegrin border
was not more than a mile away, right at the top of the precipitous
mountains that surround the little town, but the passage of arms
across it was forbidden, and so strictly was this law enforced that
people crossing from or into Montenegro were compelled to leave
their rifles and even their revolvers with the guard at the frontier, until
they returned. Everything that passed into Montenegro was
subjected to close inspection by the Austrian troops, and it seemed
to me, as I first studied the situation, that the delivery of a cargo of
contraband to the little principality would present many unusual and
interesting difficulties.
I met the diplomatic agent, by appointment, at the old Jerusalem
Coffee House, near Corn Hill, and he showed me a commission from
Prince Nicholas himself to establish his responsibility. He wanted me
to deliver a cargo of arms at Cattaro for Montenegro and said he was
willing to pay liberally but not extravagantly for the service, as the
danger, to one skilled in the handling of contraband, would be slight.
I inquired what he proposed to do with the arms after they reached
Cattaro, as their importation into his country was forbidden, but he
politely replied that that was something with which I need not
concern myself, inasmuch as he could positively assure me that I
need have no fear of having my ship seized at Cattaro or getting into
trouble there. He told me the Montenegrins proposed to take
advantage of the Russo-Turkish war, which was then certain, though
it was not formally declared until April 27, to make a determined
effort to throw off the Turkish yoke, and that the arms were urgently
needed for that purpose. He said that if the Porte heard so much as
a hint that they were buying arms I might be stopped by a Turkish
ship; therefore the greatest secrecy must be maintained and I should
be prepared with a full set of forged papers which would be so
convincing that any Turk who might board my ship would be afraid to
inspect the cargo for fear of offending England.
We came to terms without any difficulty, as I was anxious to get back
into my own business, and, as I had no ship of my own, I chartered a
small steamship for the voyage. The arms were shipped to
Amsterdam, to conceal their real destination, and I picked them up
there, after they had been repacked into cases weighing from one
hundred and fifty to two hundred pounds. This was done so that they
could be taken up the mountain-side from Cattaro on muleback
without unpacking. There were about ten thousand rifles and a great
quantity of ammunition. We encountered no inquisitive Turks and the
trip was made without incident. Cattaro is buried at the head of the
Bocche di Cattaro (mouths of Cattaro), a great S-shaped bay, and
rare scenic views of impressive grandeur were opened up to us with
every turn of the tortuous channel, as we wound our way through it.
Bold, bluff mountains ran right down to the water’s edge and off to
the north were the high peaks of Herzegovina.
According to programme, we got up to Cattaro just at dusk and after
the custom house had closed. As soon as we had made fast a
Montenegrin official, who had been waiting for us, came aboard, paid
me my charges in gold, and asked me to get the cargo out as quickly
as possible. With the appearance of the first boxes a long string of
pack ponies came trotting down the dock, and as fast as they were
brought up from the hold the boxes were placed on their waiting
backs and hustled off up the mountain-side. By daylight the whole
cargo was across the frontier, or close to it. I could not but feel that I
was taking some chance in letting it go so unceremoniously, but I
had been so convincingly assured, both by the diplomatic agent in
London and by the official who took charge of the unloading, that
there would be no trouble for me, that I decided to run the risk. When
the custom house opened I presented my papers, which called for a
cargo of general merchandise. No questions were asked as to the
disposition of the goods and I was given a clearance, or permit to
leave the port. This clinched my suspicion, which had been growing
stronger with each of the preceding incidents, that the arms were
imported with the secret approval of the Austrian Government.
Austria had previously proved her friendship for Montenegro by
refusing to allow the Turks to occupy Cettinje, the capital, after they
had suppressed the last revolt. The Montenegrins rose again during
the Russo-Turkish war, which began soon after our arrival at Cattaro,
and, with the aid of the arms I had carried to them, finally achieved
their long-prayed-for independence, which was acknowledged by
Turkey in the Treaty of Berlin.
I devoted a few days to a visit in Cettinje, which, far from what my
imagination had pictured it, was nothing but a collection of hovels,
but the people were in marked contrast to their surroundings and
made up for the shortcomings of their homes. The men were tall,
very few of them being under six feet, and handsome; the girls were
beautiful, with the grace and features of nobility, but, as most of the
hard work fell to them while the men protected them, they aged
quickly. In their picturesque native costume, resplendent with
crimson and gold, they were the handsomest race I had seen in
Europe. War enthusiasm was rampant and nothing else was talked
of. I was tempted to stay and fight with them; if I had known their
language I think I would have done so, for they are born warriors and
the love of it will never fail them. Their dream, as with all of their race
in the Balkans, is the restoration of the great Servian Empire of six
hundred years ago, which included practically all of the peninsula,
and so long as they exist they will be trying to drive the Turk out of
Europe.
I loafed along through the Mediterranean on my way back to London
and spent the next year or more in enjoying myself and squandering
money, which, in those days, was my favorite pastime after a series
of adventures. I knew I had only to go to sea to coin more money, so
the spending of it produced nothing but pleasure. In the Spring of
1879, with the breaking out of the boundary war in which always
aggressive Chile was matched against Peru and Bolivia, which two
neighbors had long been in secret alliance to guarantee the
independence of each other, the call to South America came to me
again. I itched to have a hand in the affair and my desire was soon
gratified when I responded to a summons from the manager for Sir
William Armstrong & Co., the gun makers. He said he had a
shipment of heavy guns for Peru, which were to be delivered at San
Lorenzo, a fort on an island, which guards the city, at the entrance to
the Bay of Callao. Callao is the port of Lima, the capital, and I was
advised that the Chilanos were maintaining an effective blockade
there. Peru had only six serviceable ships when the war started.
Chile had a much stronger fleet though her ships were of inferior
speed. She had so many of them, however, that Peru had been
unable to raise the blockade. After stating the situation, Armstrong’s
manager sent me to Great Portland Place to interview the Peruvian
naval attaché, who had charge of the shipment. “It is a ticklish job,”
was the manager’s parting advice. “You will find spies all along the
line and it will require all of your skill to deliver the cargo. Don’t be
mealy-mouthed about the price you ask for it.”
I agreed with the naval attaché to deliver the guns at Callao for fifty
thousand dollars. He was inclined to haggle over the price, but came
to my terms in the end. It was stipulated that I was to receive that
amount if the cargo was delivered or if my ship was sunk by the
Chilanos while defending herself, whereas if I was captured or if I
sank the ship to avoid capture, I was to get nothing. I knew I would
need a ship that could do sixteen knots an hour or better for this
undertaking and as I preferred to own her, so that I could do what I
pleased with her, I bought the “Britannia” outright, for seventy-five
thousand dollars, from the London and Hull Steamship Company.
She had done seventeen knots, and probably could do it again, and
was strongly built, though she was not intended for a dead weight
cargo in deep-sea sailing.
In the eyes of international law carrying arms, or other contraband,
for warring nations is very different from furnishing munitions of war
to rebels, though the moral principle, as I see it, is the same. In the
first instance, friendly powers, so called, are glad to furnish the
warring nations with guns, with which they may kill each other off, at
a profit to their own citizens. In this case it is a survival of the fittest,
with the peaceful nations extending their sympathy to both of the
fighters and their aid to the one with the deepest war chest. On the
other hand, the sale of arms to rebels is forbidden, regardless of the
fact that there can be no revolution without a rebellion, and that it is
only through revolution, which is simply evolution, that mankind has
advanced out of the so-called dark ages, even though they may
have been, after all, the best. With the rebels, no matter how lofty the
principles they are fighting for, it is not at all a question of the survival
of the fittest, but the perpetuation of the government that is, no
matter how bad. The “comity of nations” is such a fearsome bugaboo
that those who revolt against the established order of things,
however galling it may be, are frowned upon by all nations and given
no rights at all. To furnish them with arms is a crime; a violation of a
law which, I am glad to say, I never have respected.
In the case of Peru and Bolivia and Chile it was a war of nations,
with all of the other powers smiling approval; therefore no trans-
shipment of the cargo, at Amsterdam, or some other convenient
clearing house, was necessary. Secrecy was required only to keep
from the Chilean Government knowledge of the fact that arms had
been shipped to Peru and, if that could not be done, to prevent it
from discovering the vessel on which they had been despatched. We
got the cargo aboard without, so far as could be seen, arousing the
suspicion of the Chilean agents, though there was no doubt in my
mind that they knew of the purchase of the guns. We then took on as
much coal as the ship would carry, including a lot of smokeless, and
got out, ostensibly headed for Japan. I promptly rechristened the
ship the “Salome” and prepared a set of papers which indicated that
we were bound for Guayaquil, Ecuador, with a general cargo. We put
in at St. Vincent, in the Cape Verde Islands, for coal, and, for the
same purpose, at Pernambuco and Montevideo. At the latter port I
took on every pound of coal the ship would hold, including a
deckload, for it was a long run from there to Callao.
I did not take a chance on going through the narrow Straits of
Magellan, and right past the Chilean port of Punta Arenas, but went
clear around the Horn. On the way down to the Horn from
Montevideo I stood far out, for I suspected that the Chilanos might
have a ship doing sentry duty at the lower end of the east coast and,
while I had no fear that she could run me down, I wished to avoid all
suspicion. When we rounded the Horn I headed straight west for
three days, until we were well clear of the coast and outside of the
regular course, and then steamed due north until we reached the
latitude of Callao. Then we began burning our smokeless coal and
headed in, slowly and cautiously. When we were twelve or fifteen
miles offshore I sighted the smoke of a vessel coming down from the
north, and, soon afterward, another one approaching from the south.
Experience and that sixth sense which every successful blockade
runner must possess, told me that they were two of the blockading
fleet. I stayed so far down on the horizon that I could make out
nothing but their smoke and watched them as they approached each
other, met, and drew apart. I waited until each of them was, as nearly
as I could calculate it, as far from what my course would be as I was
from the harbor, and then made a dash for it, taking chances on
finding one or two guard ships on post right in front of the city, and
prepared to show them my heels the moment I sighted them. Luckily,
there were no ships off the harbor nor did either of the patrol ships
sight me, and I sailed up to the government dock with no more
trouble than if I had been going into Liverpool. The guns were taken
out and I received my money, which was the easiest I had ever
honestly earned, but it was because I understood the game and had
been careful.
While the cargo was being unshipped the blockaders learned that I
had run past them and, to get even with me, I suppose, they laid in
wait for us to come out. That did not worry me, however. I was in no
particular hurry to leave and waited until they were weary of
watching. Then, on a dark night, I stole out, hugged the shore to the
south and slipped away from them, without having as much as a hail
thrown at me. I restored the ship to her proper name and self but
took the same course back again around the Horn to keep clear of
any entangling alliances with the Chilean warships. I put in at
Buenos Ayres for coal, picked up a cargo for Liverpool, and on my
arrival there resold the ship for a few thousand dollars less than I
had paid for her.
CHAPTER XI
STEALING A BRITISH SHIP
IN the old days, when I was cavorting with contraband throughout

the West Indies and South America, I ran into one unpleasant
incident which left me with a large moral,—or immoral, according to
the point of view,—obligation on my hands. During a quiet spell I had
bought, at a bargain, a little schooner at St. Thomas, loaded her with
mahogany at Santo Domingo, and started for Liverpool, to see what
was going on in that part of the world. We were caught in a heavy
gale and were forced to run into Yarmouth, Nova Scotia, where we
arrived in a sinking condition. On the false charge that my papers
were forged the agent for Lloyds’, with whom the ship was insured,
seized the vessel as I was having her repaired, and had me arrested
for barratry. I was taken to Halifax, where I was put to considerable
inconvenience in securing bail. I pleaded my own case and, as soon
as I could get a hearing, was released, but in the meantime the
agent for the underwriters had libelled my ship and sold her at
auction, and her new owners had sent her away to South America. It
was a downright steal but I did not consider it worth my while to stay
there and fight the case, so I simply swore to some day make Lloyds’
pay dearly for the loss of my ship, and let it go at that for the time
being.
My last real adventure had ended with the burial of the “Leckwith,”
for there had been nothing thrilling in the delivery of the arms I had
carried to Montenegro and Peru, and I was hungry for some new
excitement, the very essence and sole enjoyment of my life. While
casting about for something to satisfy my appetite the recollection of
the Yarmouth outrage came over me and I decided to steal a ship
and let the underwriters pay for her, as partial compensation for the
one they had stolen from me. After a survey of the available supply,
following my return to London from Peru, late in the Summer of
1879, I hit on the “Ferret,” a handsome and fairly fast little passenger
steamer belonging to the Highland Railway Company, which was
lying at Gourock Bay on the Clyde. They would not let her out on a
general charter, which was what I wanted, so I concluded to charter
her for a year for a cruise in the Mediterranean, with the option of
purchase for fourteen thousand pounds at the end of that time. All of
the negotiations were conducted and the deal closed by Joe Wilson,
my trusted aide, and I was careful to impress him with the necessity
for the insertion of the option of purchase clause. I had so much
confidence in him that I did not closely examine the charter papers
and not until it was too late did I discover that he had neglected to
cover the one vital point. My plan was to go back out East and dig up
the guns which Frank Norton and I had buried on a little island when
we left the China Sea, and perhaps, if I found that I could stand it to
revisit the scenes of the supreme joy and sadness which had come
to me with the discovery of the Beautiful White Devil, resume the
unholy occupation of preying on the pirates between Singapore and
Hong Kong. I wanted the option of purchase clause inserted in the
charter partly as a sop to my conscience and partly with the idea that
if we were, by any remote chance, apprehended before we reached
the China Sea, I could announce that I had exercised my option and
was prepared to pay for the ship. I was not sure that my conscience,
for I still had one, would let me carry the deal through, and I figured
that I could comfort it, if it troubled me too much, with the assurance
that I might really buy the ship after all, though I am frank to say I
had no such intention.
With the delivery of the charter, in proper form as I supposed, I made
a great show of fitting the ship out for a yachting cruise, at the same
time smuggling on board two small cannon and a lot of rifles and
ammunition. Lorensen, my old captain, was seriously ill, so I took on
as sailing master a man named Watkins. He was well recommended
but it later developed that he had a strain of negro blood and a well-
defined streak of yellow. Tom Leigh, one of my old men, was first
officer, and next to him was George Ross, another new one. We
coaled at Cardiff and cleared for Malaga. We passed Gibraltar late in
the afternoon, as was intended, and signalled “All well” to the
observer for Lloyds’. As soon as it was dark we headed over toward
the other shore for twelve or fifteen miles and then stood straight out
to sea again. As we made the second change in our course we stove
in a couple of our boats and threw them overboard, along with a lot
of life preservers. I wanted to make it appear that the “Ferret” had
foundered, and we ran into a heavy blow which dovetailed beautifully
into my scheme. At daylight we were well clear of Gibraltar but within
sight of the Morrocan coast. I called the crew aft and addressed
them to this effect:
“Taking advantage of the option of purchase clause in the charter, I
now declare myself the owner of this ship and will pay for her, as
stipulated, at the end of the period for which she is chartered. We
are going on a very different trip from that for which you signed. It will
be attended by some danger but, probably, by profits which will more
than compensate you for the risk you run. Those of you who wish to
go with me will receive double pay, a bonus of fifty dollars for signing
new papers, and a share of the profits from the trip. Those who do
not care to go may take a boat and go ashore.”
Every man agreed to stay with me. I thereupon rechristened the ship
the “India,” a name legitimately held by a vessel on the other side of
the world, as was indicated by Lloyds’ register, fired a gun and
dipped the flag and declared her in commission. At the same time I
rechristened myself, a ceremony to which I was equally accustomed,
and took the name of James Stuart Henderson. I presented the ship
with a new log and certificate of registry and other necessary papers,
from the counterfeit blanks I always carried, and all of the men
signed the new articles. We then headed for Santos, Brazil, with the
idea of keeping clear of British waters until the loss of the “Ferret”
had become an established fact. On the way the brass plate on the
main beam, showing that the engines were built for the “Ferret,” was
removed, and the new name took the place of the old one
everywhere about the ship. The chart room and wheelhouse were
taken off the bridge and rebuilt over the wheel amidships. Some of
the upper works were stripped away and the whole appearance of
the vessel was changed to such an extent that even her builders
would hardly have recognized her.
At Santos I bought outright a cargo of coffee and headed for Cape
Town, South Africa, where I consigned it to Wm. G. Anderson & Son,
with instructions to sell it for cash, and quickly. On the trip across the
Atlantic, Ross, the second officer, who had been one of the boldest
at first, all at once became very anxious regarding the outcome of
the trip and his future welfare. Watkins, the sailing master, who had
shown a domineering nature that I did not like, also hoisted the white
feather. Griffin, too, the chief engineer, displayed some symptoms of
cold feet, but he was a brave man at heart and his trouble was easily
cured. I allowed Ross to return to England from Cape Town, and
Watkins caught the gold fever and started for Pretoria. I had no fear
that either of them would engage in any unwise talk, for both had
signed forged articles with their eyes wide open. I made Leigh sailing
master and we cleared light for Australia, with a short stop at the
Mauritius for coal. We coaled again at Albany, West Australia. From
there we went to Port Adelaide, South Australia, and then on to
Melbourne, where we came to grief. Off Port Philip Head we
signalled for a pilot and a canny Scot came aboard. He seemed
suspicious of us from the first and I noticed that he was studying the
ship closely as we steamed up to an anchorage off Williamstown.
Two young royal princes had just arrived on a British fleet and there
were gala goings-on when we entered the harbor.
I landed at once and went to the Civil Service Club Hotel to
recuperate from a bad case of malaria which I had contracted at the
Mauritius. While not alarmed by the apparent suspicion of the pilot, I
was impressed by it, and gave strict orders to Leigh to allow no one
to come aboard. Leigh’s one weakness was drink and to guard
against his becoming helplessly intoxicated I instructed Wilson to
either remain on board or visit the ship every day. My fever grew
worse after I went ashore and in two or three days the doctor
decided that I should have a nurse, as I was all alone. The doctor
was with me when the nurse arrived and as he entered the door the
doctor made a quick movement as though something had startled
him, and looked from one of us to the other in amazement. I could
not imagine what had happened until he said: “That man looks
enough like you to be your twin brother. I never have seen such a
resemblance between two men.”
I surveyed the nurse more critically and saw that we did look
strangely alike, even to the scarred face. He had a scar on his left
cheek, whereas mine is on my right, and it was shorter than mine,
but it served to heighten our resemblance. We could not have been
more alike in build if we had been cast from the same mould, and
any one who did not know us intimately could easily have been
excused for taking one of us for the other. The nurse said his name
was William Nourse and that he had arrived in Melbourne only two or
three days before from Tasmania, where he had worked in the
Hobartstown hospital. As we got better acquainted he told me he had
had a run of hard luck in Hobartstown; that his wife had deserted him
and he had taken to drink and lost his position, and that he had
come to Australia to make a fresh start.
While I was recovering at the hotel events were transpiring in
connection with the ship which tended to dissuade my spirit from
becoming overproud. Wilson, it developed, soon relaxed his
vigilance and gave himself up to pleasures ashore but without
coming near me, whereupon old Leigh blithely betook himself to his
beloved bottle. After a few days the shrewd Scotch pilot paid the ship
a friendly visit, found Leigh full three sheets in the wind, encouraged
him to proceed with his potations until he fell asleep, and then went
over the ship at his leisure, taking measurements and making
observations. Naturally, her measurements corresponded exactly
with those of the “Ferret,” which had been reported as missing with a
probability that she had gone down in the Mediterranean, and he
reported his suspicions and the result of his investigation to the
authorities. Being a Scotchman he was not actuated so much by
honesty and a desire that right should prevail as by the expectation
of a substantial reward. The ship was promptly seized for some
technical violation of the port regulations, which gave the officials an
opportunity to make a detailed inspection and take all of her
measurements, and Leigh and the few members of the crew who
were on board when the seizure was made were detained there.
Leigh refused to say a word but one or two of the crew, believing the
fat was in the fire and wishing to save their own bacon, told enough
to confirm all of the suspicions that were entertained regarding us.
Leigh was then formally placed under arrest and search was
instituted for Wilson and me.
I was greatly surprised when, late one afternoon about ten days after
our arrival at Melbourne, I received word from Joe that the ship had
been recognized as the “Ferret” and seized, that he had taken to the
bush and that I had better disappear as quickly and quietly as
possible if I wished to escape arrest, for the officers were looking for
both of us. Fearful, for the first time, that Joe had made a mistake,
and cursing my carelessness, I dug into my papers and discovered
that the charter contained no option of purchase clause. That made it
serious business and I understood why Joe had taken such
precipitate flight. I knew if I stayed at the hotel my arrest was only a
matter of a few hours and that if I sought to escape, the chances
were that I would be caught, but I determined to make a try for it. By
that time I was able to be up and walk around my room, though I had
not left it, but I had Nourse pass the word around the hotel that I had
had a serious relapse and was in such a precarious condition that I
must not be disturbed by visitors nor by any noise near my rooms.
I told Nourse that a warrant was out for my arrest on some technical
violation of the port regulations and that, while I had no fear of the
result of a trial, I did not feel strong enough to go through it, and
therefore I intended to leave at once and secretly and stay away until
the trouble blew over. He agreed to go with me and soon after dark
we left the hotel quietly by a rear entrance which opened onto an
alley. I left behind all of my luggage except a bag in which I carried
about five thousand, five hundred pounds in gold and Bank of
England notes, and a few articles of clothing. We engaged a carriage
and drove to a suburb on the railroad running to Sydney, where we
stayed all night, as all of the evening trains had left. My idea was to
get to Sydney or Newcastle, where I hoped to bribe the captain of
some outgoing ship to take me on board as a stowaway. We took the
morning train and rode as far as Seymour, about seventy-five miles
from Melbourne. There we hired a rig and drove across country to
Longwood, where we picked up the railroad after it had passed an
important junction point which I wished to avoid as I feared the
officers would be watching for us there. On the long drive to
Longwood I became convinced that my capture was certain, for the
country was so thinly settled that we were sure to attract attention
and be easily followed, if we undertook to drive through it, while if I
stuck to the railroad I was sure to be apprehended. In seeking some
new way out of the dilemma I conceived the idea of having Nourse
take my place. There was no reason that money could not remove to
prevent him from doing so, for neither of us was known, and a
physical description, such as the police would have, would fit either
of us. I was becoming more and more apprehensive of danger and
as we neared Longwood I put the proposition up to him.
“What do you say, Nourse, to changing places with me and letting
yourself be arrested, if it comes to that? I will engage a good lawyer
to defend you and even if you should be convicted, which I doubt,
you would not have to spend more than a few months in jail, at the
most. You are strong and could stand the confinement, while it would
about put me under the turf. According to your own story there is no
one who cares what trouble you get into, and even if you went to jail
you probably would be as happy there as anywhere. How much will
you take to do it?”
“I had been thinking of that very thing,” he replied. “I don’t care much
what happens to me, but I am not exactly hungry for a long term in
Pentridge. If this thing is no worse than you say it is, though, I’ll swap
places with you and see it through for two hundred pounds.”
I accepted his terms without argument. He already knew enough
about me so that he could adopt my identity, without fear of detection
except under a searching inquiry, but I quickly framed up a life
history for him and told him the full and true story of the “Ferret.” I
cautioned him, however, if he was arrested, to make no statement of
any kind until he had talked with the lawyer I would send to him. As
soon as we reached Longwood we exchanged clothing, even down
to our underwear, socks, and shoes. Nourse was transformed into
James Stuart Henderson, dressed by Pool of London, and I became
a rather shabbily attired nurse. I paid Nourse his money, which
relieved me of most of my load of gold, and concealed the rest of my
money in my rough and roomy shoes and under my more or less
dirty garments.
We had just finished dinner and were sitting alone in the hotel office,
rehearsing the part Nourse was to play, when a sergeant and two
officers, who had got track of us at Seymour, rode up on horseback.
We saw them through the window and I moved back into the shadow
for, though I did not look greatly unlike Nourse in our changed garb, I
did not wish the officers to notice our facial resemblance. With only a
glance at me they walked right up to Nourse and placed him under
arrest. He professed amazement but readily admitted that he was
James Stuart Henderson. He said he was driving through the
country, with a nurse, for his health, having just recovered from the
fever.
The orders of the officers called for the arrest of only one man so I
was not interfered with. They were after big game and, much to my
satisfaction, considered me hardly worthy of their notice. Still anxious
to avoid close range comparison with Nourse, I did not return to
Melbourne on the same train with them the next morning, but went
down by the one that followed it. I kept well clear of the jail to which
the bogus Henderson had been hustled and went to a little hotel on
Swanston Street, kept by a German named Hellwig. The first thing I
heard was that Joe, who had taken the train ahead of me, had been
captured at Albury, where the railroad crosses the Murray River,
which divides Victoria from New South Wales, and was on his way
back, in charge of an officer, to join Leigh and my counterfeit
presentment behind the bars.
I at once engaged Jarvis, the best barrister in Australia, to defend
them, and later employed Gillette & Stanton, another high-class firm,
to assist him. I told them, of course, the real facts, and had them
instruct Leigh and Joe to coach Nourse in the part he was to play
and to maintain the proper attitude toward him. The moment Leigh
saw “Henderson” he knew there was something wrong somewhere
but he was too shrewd to indicate it and greeted the newcomer
cordially. I had described Leigh to Nourse so that he could not
mistake him and he walked right up to him and shook hands. When
Joe joined them in jail Leigh got to him first and posted him. They
were charged with conspiracy and barratry and were indicted,
altogether, on seven counts.
Nourse was as game as a hornet and played his part well, yet he
was not born a gentleman and he was altogether lacking in that
savoir faire which is regarded as a necessary makeup of the typical
soldier of fortune, which Henderson was supposed to be. George
Smyth, the prosecuting attorney, was a shrewd chap, as well as a
gilt-edged sea lawyer, and it was not long until he began to suspect
that he had a bogus Henderson in limbo and that the real ravisher of
maritime law was still at liberty. Some of the other officials came to
doubt that they had the right man and this suspicion became so
strong by the time the trial came on that they had detectives out
quietly searching for the real Henderson. This information reached
the lawyers whom I had employed, but whom I saw infrequently as I
remained discreetly in the background, and they insisted, as they
had previously suggested, that I go away until the case was
concluded.
“This case is much more serious than you realize,” said Gillette, as
he again urged me to leave Melbourne for my own protection, or go
into close hiding and stay there. “Unfortunately, Nourse is not nearly
so clever as you. You are damned clever, but you are not clever
enough to avoid being nabbed if you stay around here while the trial
is on.”
“I think you’re wrong,” I told him, “but I’m paying you for your advice
and if it is good enough to buy it ought to be good enough to take. I’ll
go out and bury myself.”
“Right,” he said. “See that you make a good job of it.”
“I will,” I replied. “I am going to bury myself in a real tomb.”
The lawyer looked up a bit startled. “You don’t mean that you intend
to kill yourself?” he asked with some anxiety.
I laughed at him. “Not much,” I told him. “I like to explore strange
lands but I always want to come back. If there really are any
detectives on my trail, the last place they will look for me is the
cemetery, and I will go out there and cache myself away in Sir
William Clark’s tomb. It is an ideal hiding place, so far as security is
concerned, and you can devote all of your thought to the trial,
without any fear that I will be discovered and disarrange things.”
“But people are buried in there,” exclaimed the man of law with a
show of horror which evidenced great reverence for the dead.
“So much the better for my purpose,” I said, as I walked out of his
office. “I’m off for my tomb.”
The idea of using the Clark tomb, which I had previously noticed
while walking through the cemetery, as a hiding place, had come to
me while the lawyer was urgently renewing his advice to me to get
under cover until the conclusion of the trial. The mausoleum was in
an out-of-the-way corner of the dead city and I knew that if I could
get inside of it I would be safe from intrusion. It was about twelve by
sixteen feet in size and was closed with a solid iron door, but above it
was a grating which would furnish plenty of ventilation.
The landlord of the hotel where I was stopping had a delightful Dutch
daughter, with whom I had become very friendly, and when I
returned there after my talk with the lawyer, she informed me that
two men had been around making guarded inquiries regarding a
man answering my description. She took them for detectives, she
said, and without knowing or suspecting why they were looking for
me she had thrown them off the scent. This convinced me that there
was a chase on, after all, and that it was getting so hot that I had no
time to lose.
With a blanket wrapped about the upper part of my body, and with
the pockets of Nourse’s dirty old white overcoat stuffed with pilot
bread, canned meats, candles, a dark lantern, and books, I went out
to the cemetery that evening. I had some doubt about being able to
get into the tomb but I succeeded in picking the lock with a piece of
heavy wire and proceeded to take up my abode with the departed
Clarks. There were three of them and from the sizes of the caskets I
took them to be father, mother, and child. There was one unoccupied
niche and in that I arranged my bed, with my blanket and Nourse’s
overcoat.
I lived in the tomb for three weeks without arousing the slightest
suspicion that it was occupied. My surroundings did not worry me at
all—in fact I never had such quiet and orderly companions—and
after I had adapted myself to them I was fairly comfortable. My meals
were simple to a degree that would have delighted a social
settlement worker. I was accustomed to softer beds, but the change
did me no harm. I did most of my sleeping during the day, when I
could not smoke without fear of being discovered, and every night,
between midnight and dawn, I took a walk through the cemetery.
Twice a week, at an appointed rendezvous, I met the landlord’s
daughter, who brought me a fresh supply of canned stuff, bread, and
reading matter, and the latest news of the trial. Twice, toward the last
of it, when I was very hungry I ventured into the outskirts of the city
and filled up at a cheap eating house. During the early morning and
evening I read by the light of the dark lantern, which was so placed,
with the blanket as a screen, that its rays could not be seen through
the grating over the door. By the time the trial was well over and I
was free to come out I had fallen into the routine of my new hotel
and was so well situated that, if I could have been assured of about
three square meals a week, I would not have complained greatly if I
had been forced to stay there six months.
The trial was held before Judge Williams and resulted in a
conviction. I had expected no other verdict, for with the option of
purchase clause missing from the charter it was a clear case. The
lawyers for the defence contended, of course, that Henderson had
announced that he had purchased the ship and that only his illness
had prevented him from so advising her owners, but they could not
satisfactorily explain why he and Wilson had taken to the bush when
the vessel was seized. Nourse was subjected to a most severe
examination by the prosecuting attorney in an effort to prove that he
was not the real Henderson, but he had been thoroughly coached by
Joe and Leigh and acquitted himself so well that much of the
suspicion which had been entertained that he was playing a part was
removed, but not all of it.
The crucial moment came when the clerk of the court called out,
“James Stuart Henderson, stand up,” and Judge Williams asked him
if he knew of any reason why sentence should not be passed upon
him. According to the lawyers, the situation was intensely dramatic.
The judge, the prosecuting attorney, and all of the more or less
skeptical officials, were boring holes through poor Nourse’s head
with their eyes. He had but to open his mouth to clear himself and
start every officer in Australia on a hunt for me from which I would
have found it hard to escape, but he was true blue. He looked back
at the judge bravely and simply said, “No, sir.”
Nourse and Wilson were sentenced to seven years and Leigh to
three and one-half years in Pentridge prison. With the time deducted
for good behavior, this meant five years and three months for Nourse
and Joe and less than three years for Leigh. When the case
assumed a more serious aspect than I had believed it would when I
bargained with Nourse to take my place, I sent word to him that I
would pay him well if he would “play the string out,” and as soon as I
left the tomb I deposited five thousand dollars which was to be paid
to him when he was released. I spent some time and considerable
money in an effort to secure a pardon for my companions, but when I
found that was impossible I returned to England, with a promise to
be back in Australia by the time their terms expired. On the long trip
back to London I spent a lot of time in reproaching myself for the
result of the unfortunate cruise. It was the first mistake I had ever
made and, while I was not primarily to blame, the responsibility was
mine, for I was at fault in not having seen that all of the papers were
in proper form. That experience taught me a lesson and I never
again fell into a blunder of that sort. The Highland Railway
subsequently sold the “Ferret” to run between Albany and Adelaide.

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Principles of Auditing and Other

Assurance Services 20th Edition

Principles of Auditing and Other Assurance Services

Principles of Auditing Other Assurance Services 21st

Principles of Auditing Other Assurance Services 19th

Principles of Auditing and Other Assurance Services

Principles of Auditing Other Assurance Services 19th

Principles of Auditing and Other Assurance Services

Principles of Auditing and Other Assurance Services

Auditing and Assurance Services 5th Edition Louwers

Solutions Manual, Chapter 7, Page 1 of 20

Solutions Manual, Chapter 7, Page 2 of 20

Solutions Manual, Chapter 7, Page 3 of 20

Questions Requiring Analysis

(c) The five major objectives of an accounting system include:

Solutions Manual, Chapter 7, Page 4 of 20

(b) The definition includes the following concepts:

(c) The five components of internal control include:

(d) The major limitations of internal control include:

Solutions Manual, Chapter 7, Page 5 of 20

(b) Obtain an understanding Inquire of client personnel.

Document the understanding Prepare flowchart.

Assess the risks of material Evaluate risk based on the understanding.

Design and perform further Analyze information obtained above.

Solutions Manual, Chapter 7, Page 6 of 20

Document the results of the risk Overall responses to risks.

Solutions Manual, Chapter 7, Page 7 of 20

1. Create and maintain a culture of honesty and high ethics

Solutions Manual, Chapter 7, Page 8 of 20

(2) In conducting audits, internal auditors appraise company policies, organization,

7-34 The weaknesses and suggested improvements are as follows:

Weakness Suggested Improvement

7-35 Multiple Choice Questions

Solutions Manual, Chapter 7, Page 11 of 20

7-37 (1) Monitoring—ongoing.

Solutions Manual, Chapter 7, Page 12 of 20

Solutions Manual, Chapter 7, Page 13 of 20

7-41 SOLUTION: Orange Corporation (Estimated time: 25 minutes)

Solutions Manual, Chapter 7, Page 14 of 20

(a) Undesirable combinations are as follows:

(1) Cash receipts and accounts receivable

(b) Assignment of functions

(1) Maintain general ledger

(2) Maintain accounts payable ledger

Solutions Manual, Chapter 7, Page 15 of 20

(a) PROSPECT CORPORATION INC.

Solutions Manual, Chapter 7, Page 16 of 20

Solutions Manual, Chapter 7, Page 17 of 20

Weakness Recommended Improvement

Solutions Manual, Chapter 7, Page 18 of 20

Weakness Recommended Improvement

Solutions Manual, Chapter 7, Page 19 of 20

7-45 SOLUTION: Willington, CPA (Estimated Time--50 minutes)

Case A—Controls appear strong; Auditor Case B— Case C—

2. Describe the scope of

Results of Tests of Controls A(1)-- A(2)Controls A(3)

4. (a) What is the

5. (b) Describe the scope

Solutions Manual, Chapter 7, Page 20 of 20

IN the old days, when I was cavorting with contraband throughout

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