My role at Smackey Dog Food is to apply the audit procedures and objectives to this company. A cursory examination reveals that there are many areas where Smackey's accounting practices can be improved. At times, there are faults with the techniques that are being used. At other times, there are faults just as much with the control systems. Inadequate control systems are often the cause of problems with a company's accounting practices, and ensuring that proper controls are in place is one of the most important roles of the auditor (CSU, 2009). In this analysis, the issues will be taken one at a time, and then some final overarching recommendations will be made to ensure that not only are these problems addressed but that systems are in place to ensure that there are no further problems.
Problem #1 -- Waste and Margins
The one-serving packages that are freshly manufactured are sold at three times the price of their other products. Waste is an issue for this product, in part because of the necessity of using fresh ingredients. From a business perspective, Smackey can set its prices at whatever level it feels is appropriate for the market, but the company should have a sense of whether or not this product is making money. Thus, the company must be able to measure this waste in order to ensure that it makes money on this product. High waste is a symptom of poor controls. A management accounting system is recommended, for example contribution margin accounting, in order to determine whether this product generates profits. Waste must be included in the cost of goods sold. This will allow for a more effective breakeven analysis (Richards, 2012). It is worth considering that an essential component of good control is measurement. Right now the company does not know how much waste is associated with this product. There is evidence of waste throughout the production department, in fact. This is fundamental, so initiating a breakeven analysis will demand that the production department is able to track waste and will help management to make better decisions about what products to carry and what products should be dropped.
Problem #2 -- The Warehouse
There are a few problems with the warehouse operations. The first is that there is little control in the accounting at the warehouse level. Only two employees have access to the inventory records, and it appears that Henry has control over those records for the most part. There is no oversight from Kim, who either does not understand inventory management and accounting, or chooses to ignore her role in the oversight of these things. As such, the inventory accounting is open to fraud at worst, and errors at best. There should be either a senior person providing oversight of Henry's activities, or an external auditor performing that function if there is no internal person qualified.
The returned dog food could be an indicator of channel-stuffing. Henry wants to move out inventory, but a significant portion of this inventory is being returned. There does not appear to be any accounting for returned inventory; it is simply pushed back out the door. Channel stuffing is illegal (Investopedia, 2012) and portrays a false picture of the firm's actual sales. This could lead the firm to overproduce, if the production manager is unaware that this activity is going on. While FIFO is allowed for inventory, returns should not be treated the same as regular inventory. Moreover, the company needs to have an allowance for returns on its balance sheet. Any returns that are subject to disposal will need to be written off. Not having an allowance for that distorts both the inventory on the balance sheet and the revenue on the income statement. A significant upgrade in terms of warehouse oversight is required, to avoid illegal and misleading activity.
It is clear that some of this inventory is being disposed of, and in all likelihood being disposed of improperly. The employees threw bags of returned food into the bin, and later took it out of the bin and put it into Henry's car. Nobody knows where it goes after that. However, this could only occur in a situation where the employees are not receiving adequate supervision, especially Henry. He could be disposing of the food in a manner that is unaccepted, or he could be reselling it for personal profit. The point is that without oversight, there are no controls, and these types of activities can occur. These types of activities also make it difficult for the company to set production at appropriate levels and to reduce waste. Everything needs to be tracked. This is a key control mechanism and would prevent this type of incident from occurring. Senior management needs to have the ability to know where its products are at any given time, without having to watch over Henry like a hawk.
Problem #3 -- The Sales Team
Jillian is unable to perform an oversight role on the sales team, because she is either unwilling or incapable to traveling to the field to implement direct oversight. She should either remedy these deficiencies or be replaced. She is currently paying them commissions before actual revenues are calculated, because they complained. She is paying commission based on projections provided by the sales people. While it is the company's prerogative to do this, such a practice is patently absurd. The company needs to pay its commissions on the basis of actual revenue generated, not on the basis of projections. In addition to the fact that this is just good financial sense, paying commissions in advance means that the company's sales reps have no motivation to work hard. This is doubly true because there is no direct oversight for many of the reps outside of the Chicago area. That the projections are off is no surprise, and it is likely that the projections are always higher than the actual sales. In order to align commissions with sales, and provide some motivation for the sales force, commissions need to be paid after the period, based on actual sales. Incentives can be built into the commission structure as well. A competent sales manager will sort out the sales department in short order, to replacing Jillian is the first step.
Problem #4 -- Hiring
As an auditor, I am not an expert of human resources matters, but the lawsuit the company is now facing from an employee fired because she does not own a dog troubles me as an auditor. The Civil Rights Act of 1964 and other acts that govern discrimination issues do not forbid the company from discriminating against non-dog owners (EEOC, 2009). However, civil case law frowns on employers firing employees without just cause. If the company has not documented a pattern of incompetence, there is a good chance the employee wins the case, as dog ownership is not relevant to the performance of her duties. This policy that the company has is therefore an unacceptable risk, and a needless one at that. A human resources professional should be consulted about drafting a set of hiring and dismissal policies that will not result in lawsuits such as this. It is also recommended that the company confer with its lawyers to resolve this situation as quickly as possible. It is further recommended that the company accounts for the risk posed by this lawsuit in its financial statements. The bank in particular wants to know about potential liabilities such as this, and failure to disclose a material risk could cause serious problems for Smackey.
Problem #5 -- Receivables
The risk posed by having Pup Stores worth 31% of overall sales is also something that should be disclosed. That Smackey's biggest customer is facing a major lawsuit is a threat to future revenues.
Smackey needs to conduct a sensitivity analysis on who this would affect its accounts receivable. Remember, the company is hoping to use its receivables as collateral on this loan, so the bank has a special interest in not only knowing everything it can about Smackey's receivables, but in ensuring that Smackey management knows everything about the company's receivables. Currently, the average age of the company's accounts receivable is 55.5 days. However, most of the early payments come from Pup Stores. If they go under, the average receivables for the rest of the business will be 67 days. This is a serious problem for the company's cash conversion cycle, and something of significant concern for the bank. The company needs to improve its receivables turnover, either by offering early payment incentives or simply by being more aggressive in collections. There should be some accounting for losses on this customer's receivables, as they are seeing a decline in cash position. They will likely stretch their payables and lengthen their cash conversion cycle, so Smackey should budget both this and a decline in revenues from this customer into its projections for the coming year.