9/22/2016

InternalAuditofProcurementactivityAcaseStudy

InternalAuditofProcurementactivityAcaseStudy
(http://taxguru.in/finance/internalauditofprocurementactivity.html)
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Background: The top management of the engineering company has been extremely happy with the performance of the outsourced internal
auditteamfortheStoresactivity(detailsgiveninthearticleinearlierissueoftheJournal).Themanagementwantstheinternalauditorstonow
assesstheprocurementactivityintermsofprocessimprovementswithoptimalcontrols,compliancewithlaiddownsystemsandproceduresand
costrationalisation.Theengineeringcompany,whoseturnoveris350crores,isintomanufacturingandgivingservicesforcoolingapplianceslike
airconditionerswindow,split,cascadeetc.,refrigerators,watercoolers.
The auditee has three units, the largest factory located at Thane with other two units at Vapi and Hyderabad. The procurement function is
centralised at Thane factory with one person each at Vapi and Hyderabad who act as coordinators. Total purchases including raw materials,
boughtoutitems,packingmaterialsandconsumablesaggregateto190crores.
Themanagementfeelsthatthereisscopeofimprovingtheprocurementactivityproceduresleadingtocostrationalisation.
The management aim also includes accuracy in financial reporting, compliance with applicable laws and regulations. The management
objectivesarealsopartofthethreepillarsoftheIntegratedFrameworkInternalControlsbyCOSO(CommitteeofSponsoringOrganisations
oftheTreadwayCommission),USA.
Methodology:
Based on the above background, the partnerincharge of the internal audit firm had a meeting with his audit manager to chalk out the audit
programme.Asafirststepaflowchartoftheprocurementactivitywasprepared.
Based on the inputs gathered during the flowcharting process and the flowchart, a detailed checklist was prepared for meeting the audit
programmeobjectives.ThechecklistidentifiedtheobjectivesforthisareaReferExhibit1.

Exhibit1:

1.Havepurchasingauthoritylimitsbeenestablished,andwhatmechanismspreventsuchlimitsbeingexceeded?
2.Areadequatepurchasingproceduresinplaceandwhatprocessesensurethattheyaremaintaineduptodate?
3.Howcanmanagementbeassuredthatpurchaseordersareissuedonlyfromauthorisedsources?
4.Whatmechanismspreventtheprocessingofpurchaseorderswithoutestablishedpolicyconditions?
5.Areallpurchaseordersformallyjustifiedandsuitablyauthorised,andhowisthisevidenced?
6.Arepurchaseordersadequatelysupportedwithsufficientdetails,descriptions,specifications,prices,deliverylocationandfreightterms
inordertoensurethatthepreciserequirementsofthebusinessaremet?
7.Whatprocessespreventthedespatchofinaccurate,incompleteorambiguouspurchaseorders?

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7.Whatprocessespreventthedespatchofinaccurate,incompleteorambiguouspurchaseorders?
8.Whatprocessespreventtheraisinganddespatchofduplicatepurchaseorders?
9.Whatmechanismsensurethatoptimalquantitiesofgoodsareorderedtosupporttheoperationalrequirementsofthebusiness?
10.Whatmechanismsensurethatallsubsequentpurchaseorderamendmentsarevalid,authorisedandcorrectlyapplied?
11.Whatmechanismsareinplacetopreventoverorderingofitems?
12.Howarepotentialvendorsselectedandwhatpreventstheuseofpoorqualityvendors?
13.Howcanmanagementbecertainthatthepurchasingfunctionfullyresearchestheoptimumsourcesfortheirrequirements?
14.Arevendorsadequatelyandindependentlyassessedforapprovedstatus,andwhatpreventsstaff/vendormisuseoftheprocess?
15.Areaccurateanduptodaterecordsofapproved/suitablevendorsmaintained,andwhatmechanismspreventeitherunauthorisedor
invalidaccessoramendmentofsuchrecords?
16. Is the performance of vendors monitored against all requirements and expectations so that unsuitable, unreliable or poor quality
suppliers can be promptly identified and appropriate action taken ? Further, whether there is a suitable vendor rating mechanism and
vendorsareintimatedoftheirratingseverysixmonths/year?
17.Wouldmanagementbealertediftherewaseitherunduepreferencebeinggiventoaspecificvendor,anunreasonabledemandbeing
placedonanyonevendororthepotentialforanunethicalrelationshipbeingestablishedbetweenavendorandpurchasingmanagement?
18.Isthereadequateliaisonbetweenthepurchasingfunctionandallotheraffectedactivities(i.e.production,sales,stockcontrol,etc.)and
howareproblemsandconflictsavoided?
19.Doesthepurchasingfunctionmaintainanadequateawarenessofmarketconditions,prices,etc.inordertoensuretheplacementof
ordersattheoptimumprice?
20.Howcanmanagementbesurethatallavailablediscountsaresuitablyexploited?
21. Where applicable, are all relevant purchase versus leasing options adequately appraised to ensure that the most advantageous
purchasetermsareutilised?
22.Howcanmanagementbecertainthatalltherequiredqualityandstandardsforsuppliedgoodsareachieved?
23.Wouldthesupplyofsubstandard,inadequateorpoorqualitygoodsbedetected?
24.Areallrejectedandreturnedgoodscorrectlyidentifiedandasuitablecreditclaimedandaccountedfor?
25.Howcanmanagementbecertainthatallthegoodsorderedandinvoicedhaveinfactbeenreceivedontime?
26.Aretheprocessesofordering,accountingandreceivinggoodsadequatelysegregatedtopreventstaffmalpractice?
27. Where goods are obtained from overseas suppliers, how can management be certain that all the relevant import and foreign
exchangeregulationshavebeenidentifiedandcorrectlyaddressed?
28. Are management provided with accurate, timely and relevant information on purchasing activities to support their decisionmaking,
etc.?

ConsideringthatthisauditinvolvedlargevolumeoftransactionsthesoftwarebeingusedinprocurementbeinganERP,thetraditionalmethod
ofmanualvouchingwouldtakealotoftimefortheaudit.ItwasthereforedecidedtouseadataanalysissoftwareIDEAtocarryouta100%
checkonalltransactionsdependingontheobjectives(usingIDEA,theauditfortheprocurementactivitywouldtakeonlyfourtofivedaysforthe
MumbaiThanefactory).Additionally,backupstepstakenintheanalysiswouldalsobeavailableinthesoftware.
Themethodologyfollowedwas,to:

1.flowcharttheprocess
2.prepareacontrolchecklist
3.pinpointcontrolweaknessesbasedonthisflowchartingandcontrolchecklist
4.conductatransactionbasedauditonafewtransactionsanddocumentation
5.useIDEAsoftwaretoconductacomprehensivecheckonalltransactionsbasedondeviationsobservedduringthemanualcheckona
fewtransactionsthisiswithaviewtoidentifycomprehensivelytheextentandvalueofthedeviationstoquantify,andalsotogivean
assurancetomanagementthatotherthanthesetransactionstherewerenodeviationsduringtheyear
6. in addition as will be seen from a few observations external evidence was also collected from vendors in the form of
quotations/statementsforcorroboratingtheinternalinconsistenciesobserved
7.giverecommendationstomakethesystemrobusttoavoidcontrollablecostsandenablesmoothoperations.

Observationsarisingfromtheinternalaudit:
Following the checklist and using IDEA, the audit was completed in a two weeks time at the Thane factory. Two more days were spent in
collecting external evidence from vendors. Since Procurement was a central function, visit to Vapi and Hyderabad was not required and all
documentation was available at Thane. Overall, there were number of control weaknesses in procurement which were leading to avoidable
costsbeingincurred.
Afewmajorobservationsonsystemsandproceduresaregivenbelow:

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1.Purchasefromdealersratherthanmanufacturers:
Materialswerepurchasedfromdealers,ratherthanfrommanufacturers.ThisledtoanextracostofRs.7.8lacsasworkedoutfromExciseGate
Passes.Thestudyestablished,insomecasesdealersmarginamountedto25%to30%.
(ManufacturersgiveExciseGatepasswhichisgiventocustomersbasedondealerpriceanddealersnegotiatesomemoremargintothisprice
based on credit terms, freight and marketing costs. The procurement function should ensure that this margin is not high as the dealer enjoys
incentivesintheformofturnoverdiscount,variousschemesfrommanufacturer).
RecommendationPricesshouldbenegotiatedwiththedealers.Possibilitiesofsourcingmaterialsdirectlyfromthemanufactueresshouldbe
investigated.
CostsavingsBasedonthisinputfrominternalaudit,thecostsavingswerearoundRs.5.6lacs.
2.Quotationsnotavailablefromallapprovedvendors:
o For raw materialformulation and packing materialformulation, quotations are not available from all approved vendors. In turn, no Quotation
ComparisonSheets(QCS)havebeenprepared.EachpurchaseshouldhaveQuotationComparisonSheet.
Recommendation Quotations should be obtained from more than one supplier, and QCS should be prepared for all orders. Monopoly
suppliersshouldbelistedseparately,andspecificsanctionofprocurementcommitteeshouldbeobtained.
(Processimprovementsuggestion).
3.OrderfinalisationbyPurchaseCommittee:
Benchmark for Purchase Order finalisation by Purchase Committee has been established at Rs.50 lacs and above. Purchase Order analysis
showsthatonly17outof512PurchaseOrdersareaboveRs.50lacsduringJanuary2003toMay2003.
RecommendationThereisaneedforincreasingnumberofordersbeingfinalisedbyPurchaseCommittee.Thebasemaybereducedinthe
rangeofPurchaseOrdersofRs.10lacsandabove.
(ProcessimprovementandcostsavingssuggestionStricterreviewwillleadtobettercontrolformajorpurchases.
Action The base was revised to Rs.10 lacs and above for all Purchase Orders. This revised base was also incorporated in the SOP
StandardOperatingProcedureeffectivefrom1stJune2003).
4.Saleofbyproductatnominalpricescomparedtosameproductbeingavailableinmarketatmuchhigherratesleadingtolosstothe
company:
ByproductbeingsoldatRe.1/perMT,basicallytoonebuyer,whilethevalueofthebyproductismuchmoreinthemarket(Themarketprice
wasknowntotheinternalauditorassimilarbyproductwassoldbyanotherclient).

Allbyproductwassoldtoonedealerwithoutinvitingtenders.Examinationofearlieryearsrecordsrevealedthatbyproducthadbeensoldatan
averagepriceofRs.200perMT,andthesamewassoldtotwoorthreedealersinayear.
Thisbeingthecase,theinternalauditor,withpermissionfromhispartner,approachedthreevendorsinthemarketdirectly,includingtwowho
hadsuppliedearlier,andobtainedquotesforthebyproduct.Samplewasdrawnfromthefactoryandsuppliedtothesebuyers.Onreceivingthe
quotesdirectlyfromvendorsitwasobservedthatthequoteswereintherangeofRs.200/toRs.220/perMT.
The main reason of this lapse was that byproduct sale was not considered to be a purchase activity and was outside the purview of the
Purchase Committee. Though transactions were huge, senior officials did not pay attention to the systems and procedures being followed in
termsofquotations,vendoranalysis,etc.ThisledtoajuniorPurchaseOfficialandStoresincharge(whocertifiedthedisposal)connivingand
ensuringthatthiswashandedoutatalmostnocosttoasupplier.
The matter was brought to the attention of the Materials Head, Finance Director and CEO. They blacklisted the existing vendor, investigated
furtherandsackedonePurchaseOfficerandStoresinchargeandalsosetupthesystemsandproceduresrecommendedbytheinternalauditor.
RecommendationSaleofbyproducttobeoverseenbyProcurementCommitteeandsaletobemadeonthebasisoftender.
(Costsavingsandsystemsstreamliningsuggestion).
Otherobservationswere:

1.IndentspendingwithprocurementfunctionformorethanamonthandnotconvertedtoPurchaseOrders.
2.Advancesgiventovendorsbutmaterialnotsuppliedforovertwotothreemonths.
3. Materials received more than the Purchase Orders but still accepted in Stores and payment made for the same. Tolerance limits for
excess material were not specified in the Purchase Orders. Vendors therefore started taking advantage of this and dumping excess
materialsincetheyknewthatthiswouldbeacceptedandnotreturnedback.
4.Freightnotbeingnegotiatedproperlywithvendorsandvendorsstartingtochargeextraathigherratesundertheguiseoffreight.
5.Casesobservedwheretheboughtoutssuppliedbythevendorandthelabourjobundertakenfromanothervendoralsoinactualeffect
wasthesamevendorintwodifferentnamesandthesamenotcommunicatedtoPurchaseCommittee.

Conclusion:Basedonthethoroughreviewandsuggestionsbytheinternalauditors,themanagementstrengthenedtheprocessesleadingtoa
robustprocurementprocessandthusconsiderablesavingstothecompany.
Source:http://www.bcasonline.org/

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