WESTERN GOVERNORS UNIVERSITY

Summary Report
RJET Task 1
Hugo Solano, 81226
Table of Contents

Horizontal Analysis......................................................................................................................................2
Income Statement...................................................................................................................................2
Balance Sheet..........................................................................................................................................3
Vertical Analysis...........................................................................................................................................4
Income Statement...................................................................................................................................4
Balance Sheet..........................................................................................................................................5
Trend Analysis.............................................................................................................................................7
Ratio Analysis:.............................................................................................................................................8
Working Capital.........................................................................................................................................10
Current State of Working Capital...........................................................................................................10
Internal Controls........................................................................................................................................11
Sarbanes-Oxley..........................................................................................................................................14
SOX Compliance....................................................................................................................................14
Corrective Action...................................................................................................................................15
References.................................................................................................................................................17

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Horizontal Analysis
Horizontal analysis is a type of trend analysis that compares both percent and amount changes from one
year to another. This type of analysis is performed on both the income statement and the balance sheet
to allow detection of trends and to identify performance issues. The analysis itself can be very useful,
especially if more than two years are included. However, caution must be taken not to draw conclusion
on this analysis itself, as it can mislead without any context. It is always important to have both company
background information, and the aid of other analyses such as ratios to help form a complete picture.

Income Statement
Revenue Sections:
From the income statement one of the most visible changes is both strength and a weakness. The jump
in Net Sales from FY6 to FY7 (up 33%) is very substantial indicating a growth year for the company and a
very positive result. Net sales are also a source of weakness when we look at the substantial drop in
sales from FY7 to FY8, where a 15% reduction took place. Normally this may be cause for alarm and
should mandate some immediate action. According to management, because their product is
dependent on professional riders obtaining sponsors, the downturned economy has cause several
sponsors to stop funding riders, and thus affected sales. This in itself could indicate that there isn’t
enough diversification in the company’s revenue sources. Although a niche industry obtains most of its
profit from its specialization, it should not depend on it as a sole source of revenue. The company is also
dependent on its innovation and market leadership to maintain brand value, so special attention must
be given to R&D and advertising funding.

A strength in this section is that COGS has been moving in proportion to sales. Although there is a small
margin of difference between the raise/fall of sales versus COGS (1.5% from FY6 to FY7 and .5% from
FY7 to FY8) the proportions do indicate that the projections being made in purchasing are accurate.
However, that gap is also an opportunity to increase profit by reducing COGS.

Selling Expenses:
A strength that can be observed here is that the company increased advertising from FY6 to FY7 by
37.5%. This is especially positive because the product depends on visibility and brand name recognition
by professional riders.

There are a few weaknesses in this section as well, mostly from FY7 to FY8. First, there was a decrease in
both advertising of 16.3 percent. As stated in the previous paragraph, one of the company’s main assets
is its brand, which represents innovation and quality professional bicycles. However, a brand name must
be supported by advertising. Sales are almost always affected by reduction in advertising. Without it
new customers won’t know about the company’s products, and existing customers won’t know about
innovations and new products. We recommend that advertising funding be increased in support of
sales.

Another potential weakness is the inactivity in the Website Creation and Maintenance section. This may
indicate that the company’s website is not being used as an active marketing and sales asset. In today’s
market, the website can help the company to diversify its revenue streams and seek out new business
opportunities that can help combat sales declines from its niche market. We recommend increasing this
allotment in support of sales and to help the company mitigate the risk related to niche market sales.

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A strength of this area is that most accounts fluctuated up and down in proportion to the fluctuation of
net sales. This indicates that there is good control in selling expenses.

General and Administrative Expenses:

This is by far the most significant source of concern in the Income Statement. A significant weakness of
this area is the rise in expenses of 20.4 percent from FY6 to FY7, and then another rise of 1.2 percent
from FY7 to FY8. The latter is especially concerning because it took place during a low net sales year.
Overall, this indicates that expenses need to be controlled more rigorously. We recommend that the
company institute quarterly budget and spending sessions to adjust expenses according to sales
performance. This allows for finer control when there is a downward trend in sales. From the entire
section we can point out several contributing factors. First, there was a substantial payroll expense rise
(21.4% administrative salaries and 29.4% executive compensation) that took place from FY6 to FY7. We
suspect that the increase in salaries was due to the growth seen by the company. We recommend that a
formal compensation plan be enacted which conditions raises based on previous year sales revenue
performance, and which spreads out the increase in small yearly increments. We are also concerned
about the 16.3 percent decrease in research and development from FY7 to FY8. The type of product and
the type of market both require steady innovation, which comes from funding R&D. This reduction can
have serious long term effects on product sales, and thus we recommend increased funding in support
of product quality and long term sales.

A final weakness in this section is the continual and disproportional growth of the Other G&A Expenses
section across all years. It is growing faster than the other expenses in the section. This suggests that
management should exercise tighter controls over miscellaneous expenses. We recommend that the
company review the contents of the accounts in this section and consider reducing these expenses in
proportion to sales (see overall recommendation above).

Both Total Operating Expenses and Operating Income show the overall weakness of the company in
controlling its General and Administrative Expenses. If the company would have exercised better control
in this area, its G&A Expenses should have fallen from FY7 to FY8 in proportion to net sales, by about
15% or about $138,617 which would have reduced the operating loss from 69% to 25%.

Net earnings show the company’s downward trend. Although earnings surged during the growth year,
they did not maintain on the following year and the decrease puts the company in a worse off net
earnings position in FY8 than where they were in FY6. Again, we can’t stress enough that the company
should diversity its revenue sources outside its niche market; invest in advertising to support sales;
invest in R&D to maintain market positioning; institute a compensation plan that spreads out salary
increases; and exercise tighter expense controls in its General and Administrative expenses areas
including quarterly budget and expense reviews.

Balance Sheet
Cash and Cash Equivalents:
A weakness in this area is the reduction of 54.6 percent in Cash from FY6 to FY7 in spite of the net sales
increase of 33%. This can indicate that most sales were made on account and remained uncollected. This
can also indicate that cash was used to pay for expenses. Another factor that may have influenced this
reduction was the Capital Stock purchase from FY6 to FY7 for $100,000. We recommend that the
company utilize more debt to pay for expenses instead of using cash.

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This account also increased by 275.4 percent from FY7 to FY8. This can be seen as a strength, and was
directly influenced by the 15% increase in receivables collection and the increase in payables debt. This
suggests that the company has begun to use debt instead of cash to pay for expenses and that it has
begun to increase its collection efforts.

Accounts Receivable:
A substantial increase (164.3% from FY6 to FY7) can be seen as weakness due to the company’s
inefficiency in collection of outstanding accounts. The company extends net 30 terms to its clients, but is
failing to collect on these terms, causing the large increase in receivables at the end of the period. We
recommend that the company increase its collection efforts on past due accounts. This can be done by
maintaining good communication with clients, sending monthly statements which include balance aging,
and by setting stricter terms on those clients that do not pay on time.

A drop of 15 percent in receivables from FY7 to FY8 is a strength for the company. The company still sold
over 5 million in this period, and a it collected over $105,000 on outstanding accounts, contributing to
its cash position.

Total Current Assets:

An increase of 16.5 percent in total current assets from FY7 to FY8 in spite of weaker net sales (down
15%) is a definite strength. This increase can be attributed to improvements in cash and increase
collections of receivables.

Accounts and Notes Payable:

A very positive trend that can be categorized as a strength is the increase of accounts payables across all
years. This means that the company is starting to leverage its debt to finance its assets. Although this is
not normally a good thing, the company’s current ratio (over 5) indicates that it has maintained a very
low proportion of current assets vs. current liabilities and that there is room to both improve cash
liquidity and still maintain a good ration (above 1.5). This is also reflected in the steady increase of Total
Current Liabilities across all years. Overall the rate of growth for assets is still greater than the rate of
growth for liabilities.

Stockholder’s Equity:
There are two significant strengths in this area. The first is the continued increase in retained earnings.
Even in a bad sales year the company has managed to support its operations with internally generated
revenues. The company will not need to issue any more stock to raise operating capital.

The second strength is the rising trend in Total Stockholder’s equity. This means that the current
investors can potentially see better dividends. This also adds value to the stock by making the company
seem more attractive to potential investors.

Vertical Analysis
Vertical Analysis is also a type of trend analysis but it sees changes differently from a horizontal analysis.
The main focus of horizontal analysis is passage of time, where the focus of vertical analysis is the
distribution of money within a period. In a vertical analysis we take a key amount (net sales in income
statement and total assets/liabilities in balance sheets) as the base and calculate what percentage each
amount constitutes within the base amount. This way we can see where the money is being spent or
earned within a period, and we can calculate changes in these allocations from one year to the other.

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Income Statement

Revenue:
The revenue section shows two important strengths. The first is that gross profit shows an upward trend
from FY6 (26.6%) to FY7 (27.4%) and FY8 (27%). This is especially significant in FY8 because of the
decline in net sales from FY7 to FY8 (see horizontal analysis of income statement, net sales). Another
strength in this area is that COGS has remained steady across all three years in proportion to net sales.
This adds stability to the company and helps it produce accurate budget estimates. The ratio of COGS to
net sales seems high (73 cents of COGS per net sales dollar) but we have to remember that the
company’s product is both skilled labor intensive and requires high quality (expensive) materials.

Selling Expenses:

A strength in this area is that selling expenses are both steady across all years and proportionally small
(6.7% of net sales). This may also indicate that the company has a very efficient sales, distribution, and
transportation operation which allow it to control its costs and keep them steady.

General and Administrative Expenses:

This area continues to be the biggest source for concern for the company. A substantial weakness is the
upward trend from FY7 to FY8 (in spite of the sales decline). A total 18.4 cents of every net sales dollar
were spent in FY8 in G&A Expenses. Overall, these types of expenses are three times higher than selling
expenses in all years.

When looked at closely, we are even more concerned to learn that the Other G&A Expenses are as much
as 3.3 cents of every net sales dollar. This is as much as administrative salaries and even more than
utilities in FY8. We recommend that rigorous expense controls be implanted to combat raising G&A
Expenses, including quarterly budget and expense reviews.

Operating Income, EBIT, and Net Earnings

All three of these areas show a downward trend indicating. The cause for these weaknesses is mainly
due to high expenses, which compounded by a bad sales year in FY8. Of the little profit that is left, most
of the Earnings Before Income Taxes (EBIT) are used to pay for the high interest expenses. We
recommend the implementation of expense controls outlined above and consideration of accelerated
payment on the company’s long term payables (mainly mortgage payable) to reduce interest expenses.

Balance Sheet
Cash and Cash Equivalents:
This area shows an important area of strength for the company in the 10.3% of cash that makes up total
assets in FY8. This high percentage of cash available to the company improves its liquidity and its credit
capabilities. This strength can be attributed to collections of strong sales in FY7 and to good collection
activity for FY8.

Accounts Receivable:
A weakness in this area is the high amount of accounts receivables that make up assets. A total 16.6
cents in FY7 and 14.1 cents of every asset dollar is owed to the company through its receivables. The
amount is not excessively high but it can be improved. We suggest that the company increase its
collection efforts on past due accounts. This can be done by maintaining good communication with

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clients, sending monthly statements which include balance aging, and by setting stricter terms on those
clients that do not pay on time.

Raw Materials Inventory and Work in Progress Inventory

Although the business does not maintain any finished product in its inventory, it does need to purchase
and inventory raw materials for production. A weakness can be observed in the high amounts of raw
materials (2.1% for FY7 and FY8) and work in progress inventory (3% for FY7 an FY8). This may point to a
deficiency in the monthly purchasing of raw material. We recommend a review of the purchasing and
inventory areas so that current material levels are contemplated in future material purchases. This
should lower inventory levels and increase the bottom line.

Total Current Assets

Some very important strengths in this area are the upward trend in total current assets from FY7 to FY8
and the high proportion of current assets to total current assets (37.2% of all assets are current assets).
This helps the company maintain a high working capital and helps it maintain very good current and acid
test ratio scores, thereby making it more attractive to outside investors and creditors.

Current Liabilities:
A very strong aspect of the company is its low amount of current liabilities. Although this figure is
trending up (FY6 2.5%, FY7 5.4%, and FY8 7%) the amount is very low. Most of the company’s liabilities
are made up of long term assets (land, buildings, equipment). This helps the company maintain very
good liquidity ratios and helps it obtain favorable credit and financing terms with vendors and lenders.

Total Current Liabilities:

This area is also a strength as total current liabilities are trending down from FY6 (47.5%) to FY7 (46.7%)
and to FY8 (45.9%). This is mainly due to the fact that the mortgage payment is relieving more debt than
the company is incurring it through payables.

Retained Earnings:
The total amount of retained earnings during FY8 constituted 28.1% of every equity dollar and it is
considered a very important strength for the company. We can say that the company’s operations are
being successfully funded through retained earnings and that the company will not need to issue
additional stock to continue funding them.

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Trend Analysis
The trend analysis provided has a substantial weakness in that the Net Sales and Net Earnings trend
results for FY6, FY7 and FY8 do not show the same pattern as the projected sales for FY9 through FY11.

Table 1 - Current Performance

Competition Bikes, Inc.

Historical Trend Analysis
December 31, Years 6-8

  Year 8   Year 7   Year 6 As we can see from the table units sold
Units Sold 3400   4000   3000
increased by 13% from FY6 to FY8, but net
Net Sales 5,083,000   5,980,000   4,485,000
Net Earnings 36,100   196,294   47,479 earnings fell by 24 percent comparing the same
Trend years.
Percentages 113.3%   133.3%   100.0%
Net Earnings Pct 76.0%   413.4%   100.0% Table 2 - Performance Forecast

Competition Bikes, Inc.

Forecasted Trend Analysis with Year 8 as base year
December 31, Years 9, 10, & 11
                 
  Year 11   Year 10   Year 9   Year 8  
Projected Units Sold 3800   3660   3510      
Net Sales 5,681,000   5,471,700   5,247,450   5,083,000  
Trend Percentages 111.8%   107.6%   103.2%   100.0%  
Increase Over Prev. Year 4.2   4.4   3.2      

From looking at the sales forecast we can see that the projections do not reflect past performance
trends for FY6 to FY8. There is also the concern about the cause for the decrease in sales from FY7 to
FY8. If the economy caused sales to retract 15 percent in one year, and if the revenue sources for the
company are professional riders who depend on sponsors to purchase the company’s product, it is
unlikely that the market can overcome this 15% downward trend and add an additional 3 to 4% upward
trend in net sales. To strengthen this area we recommend that the company review the sales projections
and that it bases them in both past sales performance and competitor/market segment performance.
Another recommendation to improve this area is to increase funding in advertising, R&D, and website
creation and maintenance. These three areas can help strengthen sales for the short and long term.

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Ratio Analysis:
Ratios in its most basic form are formulas used in financial analysis to evaluate the proportion of one
amount to another amount within a financial statement. Rations can be used to evaluate performance,
liquidity, debt, creditworthiness, collection performance, payment performance, inventory efficiency,
among many others.

Current Ratio – Strength

A current ratio of 5.35 in FY8 considered a strength for the company. This means that the company has
$5.35 of current assets for every dollar of liabilities. A figure of 1.5 is considered good, and in
comparison with its competition, Two Wheel Racing, it is also superior (4.2 in FY8). The high score can be
attributed to the shrinking liabilities and to continued growth in current assets. This high ratio allows the
company to seem better performing in comparison to its competition (in the eyes of investors) and
allows the company to acquire financing more easily by appearing a safer lending risk (in the eyes of
lenders). The ratio does however suggest that the company has room to put more assets to work
towards its operations and still have a significantly good current ratio.

Acid-Test Ratio – Strength

This more stringent measure of liquidity is also a strength for the company. Its current score of 4.25 in
FY8 is substantially higher that the manufacturing norm of 1.0 and still higher than its direct competition
(Two Wheel Racing, 3.4 in FY8). As is the case in the current ratio this ratio score helps the company in
investment and financing. This ratio is closely related to the current ratio because the company does not
maintain a finished goods inventory, and because its raw materials and ‘in-progress’ inventories are
relatively small.

Collection Period - Weakness

An average collection period of 48 days for FY8 indicates that most of the company’s customers are
complying with the sale terms as agreed. In contrast the competition (Two Wheel Racing, FY8) had only
an average collection period of 32.5 days. This shows that the company is not collecting on its accounts
as efficiently during the period, allowing them to become past due. We recommend that the company
increase its collection efforts on past due accounts. This can be done by maintaining good
communication with clients, sending monthly statements which include balance aging, and by setting
stricter terms on those clients that do not pay on time.

Debt Ratio – Strength

The debt ratio of 45.9% in FY8 is seen as a strength for the company. This figure is below the 57 to 67
percent considered normal for the industry. Because of this ratio score the company is seen more
favorably when asking for financing from lenders. This also points to the fact that the company does
have room to use more debt to finance operations and still remain an acceptable financial risk to
lenders.

Gross-Profit Margin – Strength

Gross profit margin remains steady at 27% (FY8) and this can be seen as a strength for the company. In
comparison to its competition, Two Wheel Racing, which had 32.1% (FY8), this low ratio indicates that
the company is more competitive in its pricing, but more importantly it also indicates that there may be
room still for the company to raise its price and still remain competitive in its market segment.

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Operating Margin – Weakness
This is a weakness for the company, as it had a score a declining score over the previous year (1.9% in
FY8 versus 5.3% in FY7) and was still below its competition (Two Wheel Racing) which had achieved 5.2%
in FY8. This decrease can be attributed in the rise of operating expenses for FY8 in spite of its net sales
decline. Recommend stricter expense controls to improve this margin.

Net Profit Margin – Weakness

This margin was at .7 percent at FY8, down from 3.3 percent on FY7. The net profit margin is also below
the competition (TWR, FY8) which had achieved 5.14 percent for the same period. This low margin is a
direct result of decreased sales and increased operating expenses for FY8. We recommend stricter
expense controls and increased investments in advertising and R&D to boost sales.

Earnings per Share (EPS) – Weakness

This important measure of stock performance is widely used by investors. The current EPS ratio of 4
cents per outstanding share of common stock during FY8 is down from 20 cents per share for FY7, and
below the competition’s 8 cents per share for FY8. Because net earnings one of the main components of
this ratio, during FY8 the decrease in net sales and the increase in operating expenses have lowered the
ratio substantially. We recommend that the company consider utilizing its cash to acquire additional
stock as Treasury Stock to raise the price of outstanding shares. We also recommend that the company
consider a reverse-split to increase outstanding share value and to avoid de-listing in the Philadelphia
Stock Exchange.

Return on Total Assets – Weakness

A return of .8 percent on total assets for FY8 indicates that the company is not using its assets effectively
to generate profit. The score is well below the industry average of 5.99% and also well below the
competition’s (TWR) 4.8% for FY8. The low score is mostly due to a very low net income for FY8, and the
effect is compounded by growing total current assets. The company can increase sales, decrease
operating expenses, and even increase product price to improve this ratio score.

Return on Common Equity – Weakness

The company’s rate of return of 1.5 cents for every dollar invested in FY8 is a weakness. The ratio is well
below the industry standard of 10.5 cents per dollar, and also below the competition’s (TWC) 8.1
percent for FY8

As in the case of Return on Total Assets, the ratio is affected by the very low net income in FY8, and the
effect is increased by the growth in stockholder’s equity for the same period. The company can increase
sales, decrease operating expenses, and even increase product price to improve this ratio score.

Price/Earnings Ratio – Weakness

Although a ratio of 89.73 for FY8 seems favorable, it is really a distortion of the base numbers used to
compute it. During FY8 the company’s average stock price was $3.10 and the EPS was .04. These low
numbers generate a high PE ratio, but this ratio does not constitute an improvement, but rather the
consequences of downward trends in another ratio and the lower stock price. To improve this ratio the
company can improve its EPS ratio, as it cannot directly control stock prices.

Times Interest Earned – Weakness

A ratio of 1.77 for FY8 in this area means that the company can only cover interest payments 1.77 times
with its operating revenues. This is considered a weakness as the U.S. average is between 2.0 and 3.0. It
can be attributed to the company’s diminished sales for the period and its mounting Operating
Expenses. Another contributing factor is the high amount of interest expenses the company pays for its

9
mortgage. We recommend that the company decrease its expenses and that it consider accelerating
repayment of long-term payables (mortgage) in order to reduce interest expenses.

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Working Capital
Current State of Working Capital
The company’s working capital is made up of its current assets minus its current liabilities and it signifies
the resources which are immediately available to conduct business and generate revenue. In order to
have a complete perspective of the company’s capital, we also need to look at its operating cycle.

The operating cycle is a multiple stage process in which inventory is purchased, goods are sold and
money is collected. The operating cycle tells us how long (in days) it takes to convert working capital into
revenue. An operating cycle also tells us if we are able to meet vendor payment terms and if our
customers are meeting their credit terms. Overall, the working cycle tells us how long out most liquid
assets are tied up in the production of revenue. The shorter cycle allows more resources (capital) to be
freed up to generate more revenue.

FY8 FY7 FY6

1,306,61 1,145,51
Net Working Capital 7   7   924,223
Pct Cash 34%   10%   28%
Current Operating Cycle
Operating Cycle Days 46.9   59.8    
Days Inventory Outstanding 21.7   27.0    
Days Sales Outstanding 47.7   52.1    
Days Payable Outstanding 22.5   19.3    

As we can observe in the above table, the company had over 1.3 million dollars in net working capital for
FY8, out of which 34 percent was made up of cash. We can also observe an upward growing trend in
both net working capital and cash makeup from FY6 to FY7 and in FY8.

Now looking at the operating cycle data we can see that overall, it takes the company 46.9 days in FY8 to
convert capital into revenue, out of which 22.5 days were payable outstanding and 47.7 were sales
outstanding.

The company currently has net/15 terms with its inventory suppliers and based in the 22.5 days payable
outstanding it is not meeting those terms. The company also extends net/30 terms for its customers for
sales on account. According to the FY8 days sales outstanding figure it takes an average of 47.7 days for
customers to pay the company. This figure also indicates a problem in the collection of outstanding
accounts.

Improving Working Capital

The company can take several steps to improve its working capital. The first is to negotiate better terms
with its suppliers. We recommend having net/30 as this will allow the company to meet its obligation
and to increase its cash resources by keeping its money working instead of in the supplier’s bank.

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The company can also improve its collection of outstanding accounts. This can be done by improving
current collection practices; including following up on customers and sending invoices which include
balance aging information. Finally, we also recommend that credit terms be lowered to net/15 for those
customers that do not pay as agreed. This should add additional cash to the company’s working capital.

Utilizing Excess Capital

Excess working capital can be used to negotiate discounts in supplier purchases when cash payments are
offered instead of paying with credit terms. This is a measure that directly impacts the company’s
bottom line (net income) and that can be easily implemented.

Excess working capital may also be used to accelerate repayment of long-term liabilities such as
mortgage payable. This will have a significant effect on net revenue by reducing interest expenses.

Finally, investing this capital in the generation of new sales can be achieved by increasing advertisement,
R&D, and Website Creation and Maintenance expenses. These three expenses directly support sales and
increase profitability both in short and long term periods.

Finally, the company may also utilize the excess working capital to finance the acquisition of additional
assets and operations to expand its production, including but not limited to additional product offerings
in other markets. Basically any use of excess working capital towards any aspect of profit generation or
debt reduction will yield better return than having the money unused and unproductive.

Internal Controls
Overall, companies must separate functions that may have conflicts of interest. For example, a single
person may not authorize a purchase and issue the purchase order as it can constitute a conflict in
interest and represents a lack of control by the company. Internal controls in general can be preventive,
detective, corrective, directive, or compensating.

The most common internal control is preventive, which seeks to put measures in place to keep
something from happening. Next most common is detective. This control seeks to detect the event after
it has happened and it’s used in conjunction with corrective, which seeks to remedy a situation after it
has been detected. Directive controls are those who seek to establish procedures or policies to deal with
events in a company. Finally, compensating controls are those put in place to deal with events that take
place in spite of other controls being in place. This can be seen as a redundant measure in case another
control fails.

The company states that its purchasing department issues (at the first of each month) its purchase order
based on a budget, to its supplier (lowest cost out of 3 quotes). It then receives the merchandise (and
sends it to production) and the invoice (forwards the invoice to accounting) for payment. It also states
that left over inventory is sent (by production) to raw material inventory at the end of the month.
[ CITATION Wes11 \l 1033 ]

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The information provided by the company shows internal control problems and inefficiencies in the
purchasing, receiving, payment and inventory processes.

Weakness: The purchasing department is making purchases without any additional oversight. It both
authorizes the purchase and issues the purchase order based on budgeted amounts.

Corrective Action: Require the person responsible for the budget to issue a purchase request
using a Requisition Form to Purchasing for the materials and the quantities needed and in
accordance to the budget

Risks of Weakness: Having Purchasing authorizing and purchasing can lead to unauthorized
purchases and possible fraud.

Risk Mitigation: By enacting a purchasing request process we ensure that only purchases that
are authorized and necessary are acquired by the Purchasing Department.

Weakness: The purchasing department orders and receives the raw materials.

Corrective Action: Separate the duties of purchasing from receiving. A receiving department
needs to count all goods and certify receipt by issuing a receiving report to the purchasing
department, the party requisitioning the goods, and the accounting department.

Risks of Weakness: Having the purchasing department buy and receive creates a substantial risk
of fraud by allowing a single person to order goods and receive them. A person could, in
collusion with a vendor, or by themselves, defraud the company by marking goods as received
that were never received, or by processing invoices of goods at higher prices.

Risk Mitigation: Having a separate party validate goods received allows for independent and
more reliable receipt of goods. It also helps catch any discrepancies and order errors. This also
makes it more difficult for a single person or a single department to defraud the company.

Weakness: The purchasing department receives supplier invoices and forwards them to accounting for
payment.

Corrective Action: Require suppliers to send all invoices directly to accounting. Accounting can
then match the requisition to the purchase order, to the invoice to the receiving report before
paying the supplier.

Risks of Weakness: Having Purchasing authorizing and purchasing can lead to unauthorized
purchases and possible fraud.

Risk Mitigation: By requiring invoices to be sent to accounting instead of purchasing we allow

accounting to independently verify transactions for Purchasing to invoices from suppliers. We
also avoid the possibility of payment delays for suppliers by reducing the amount of people that
invoices must go through before being paid. This corrective action also helps the accounting

13
 department verify from three independent sources that the order information is accurate and
that the purchase has been authorized.

Weakness: The accounting department is recording transactions and issuing payment checks for
supplier invoices.

Corrective Action: Separate the recording and reconciling of purchase transactions from the
issuance of checks to suppliers. Establish a voucher payment-request system to record payment
authorizations. Have accounting issue the payment voucher after all documentation is verified.
Require that an outside party like a Controller or a Treasurer issue the checks based on payment
vouchers received from accounting.

Risks of Weakness: Having accounting verifying purchases and issuing checks creates cash
control issue as there is no other party verifying that the release of cash (a check) is done for
authorized and correct amounts. There is also a risk of over/under payment of balances either
by mistake or with the intention to defraud the company. Finally, without a voucher system
there is no evidence of who approved the payment and disbursement of cash.

Risk Mitigation: Separating the functions of accounting and payment is essential to detect
differences between the goods purchased and the cash disbursed to suppliers. Also, having a
payment voucher system allows detection of incorrect payments to vendors and allows the
company to identify irregularities in the disbursement of cash. Finally a payment voucher system
allows the company to evidence and review past cash disbursements by vendor or by approver
to identify any problems in recordkeeping.

Weakness: Inventory is not being performed on raw materials and current left-over materials are not
being used to reduce future monthly budgeted purchases of goods.

Corrective Action: Require the production line to inventory raw materials so that the amount of
goods on inventory can be used to offset the month’s materials purchase.

Risks of Weakness: Purchasing the full budgeted amount is inefficient and generates increasing
amounts of left-over raw materials which can be used to supplement monthly purchases but
instead are rolled from one month to another, tying up the company’s cash.

Risk Mitigation: By maintaining an accurate inventory of raw materials, and using this inventory
to supplement monthly purchases we ensure that the company does not purchase goods it
already has in hand, saving cash and possible delivery and labor expenses. We also ensure that
cash is not tied up in inventory by using any left-over materials to manufacture in future
months.

Weakness: Numbered documents are not being used to ensure proper tracking and verification of
transactions.

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 Corrective Action: Issue numbered purchase requisitions, receiving reports, payment vouchers,
and purchase order forms.

Risks of Weakness: Documents that are not pre-numbered create the risk of alteration and are
difficult to trace and track.

Risk Mitigation: By using numbered forms the company can keep track of the sequence of the
transactions and can easily tie a requisition to a purchase order and a receiving report. This also
allows better communication about the orders but helping people reference a distinct document
number when referencing a transaction. Finally, serializing documents allows accounting to
verify and cross-reference transactions from different areas (purchasing, receiving, and
accounting) for the purposes of auditing and fraud detection. Things like detecting duplicate
orders under the same number (multiple copies), mismatched purchase orders to invoices,
stolen/lost forms, and unpaid invoices are some of the conditions that can easily be verified
using serialized forms.

Sarbanes-Oxley
The Sarbanes-Oxley Act of 2002 (SOX) was created to ensure that public companies reported accurate
information in their financial statements. The law was a response to several accounting scandals such as
Enron and WorldCom, which severely affected investor confidence in the accuracy of these financial
statements. Overall the law lays out management’s responsibilities of enacting and verifying internal
controls to ensure the accurate reporting of financial information. The law also creates the Public
Company Accounting Oversight Board (PCAOB) to oversee the work of auditors and sets down civil and
criminal penalties for misrepresentation of information in financial statements [ CITATION Sar \l 1033 ].

The law’s two most significant sections are:

 Section 302: This section establishes that management is responsible for establishing,
maintaining, and verifying internal controls to ensure that material information is made known
to corporate officers, especially during the periods that financial statements are prepared.
 Section 404: This section establishes management’s responsibility of reporting on the
effectiveness of internal controls over financial reporting. This accomplished by implementing an
internal control framework such as the one outlined by COSO. This section also requires the
company’s external auditor to report on the effectiveness of the internal controls.
 Section 802: This section deals with criminal penalties (up to 20 years prison and fines) for
violations to the Sarbanes-Oxley Act provisions.

SOX Compliance
The first compliance issue referrers to the weaknesses identified by the Internal Controls section of this
report. These internal control deficiencies are material and go to the heart of SOX compliance. If the
company is to state that it has reviewed its internal controls and that it has found them to be adequate,

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it must first correct deficiencies related to requisitioning of goods, purchasing, receiving, raw materials
inventory, cash management, and documentation of transactions.

Another compliance issue is that Competition Bikes, Inc. year-end report [ CITATION Wes11 \l 1033 ]
states that it has “designed a system to provide reasonable assurance to management…” about the “…
preparation and fair-presentation of published financial statements.” This statement is not compliant
with the requirements of SOX as it is management who is responsible for designing, maintaining and
verifying these internal controls systems, and not how the financial statements are prepared or if they
are fairly presented.

Another compliance issue is that management is not stating whether an external auditor has evaluated
the internal controls to verify their effectiveness.

Corrective Action
The first recommendation for SOX compliance is to address the material weaknesses in internal controls
identified in the following areas:

 Goods Requisitioning: The company needs to establish a requisitioning system where the
person with budget authority requisition for the needed goods.
 Purchasing: The purchasing department must only be allowed to receive requisitions, select the
lowest cost materials, and issue a purchase order. It should be excluded from requisitioning,
receiving, or invoicing.
 Receiving: The company needs to establish a receiving system where a person will count all
merchandise received and issue a receiving report to accounting, purchasing and the
requisitioning party.
 Raw Materials Inventory: The company must establish a raw materials inventory process to
ensure that any raw materials not used during previous months are used towards future
production of goods.
 Cash Management: The company needs to separate the accounting and verification documents
from the issuing of payment to the suppliers. The accounting department should verify and
record transactions, including the requisition of goods, the receiving report, the purchase order,
and the supplier’s invoice. The company should institute a payment voucher system to control
payment authorizations.
 Documentation of Transactions: The company must issue sequentially pre-numbered forms for
all its requisitioning, purchasing, receiving and payment processes to ensure proper tracking and
accounting of all transactions.

We also recommend that the company separate its compliance statement into sections that directly
relate to SOX requirements. Instead of issuing general narrative statements, the company should divide
information into sections such as “SOX 302 Compliance” where it would list all the information required
by the section and would describe how it complied. This helps provide clear and precise information to
outside parties about the company’s compliance of SOX.

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Another corrective action would be to re-word the statement about the company’s SOX Compliance in
accordance to SOX requirements [ CITATION Sar \l 1033 ], to state that “management is responsible for
establishing and maintaining internal controls” and that it has “designed such internal controls to ensure
that material information relating to the company and its consolidated subsidiaries is made known to
such officers by others within those entities, particularly during the period in which the periodic reports
are being prepared.”

Additionally, we recommend that the company request a report from its external auditor regarding the
effectiveness of the internal controls over financial reporting, and that it include a statement indicating
the results of such a report.

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References
Sarbanes-Oxley Act of 2002, Pub. L. No. 107-204, 116 Stat. 745.

Western Governors University. (2011). JET2 Financial Analysis. Retrieved 02 23, 2011, from TaskStrem:
http://file.taskstream.com/file/bt9a28Upp2h0H6g5evMuvshvM25mlkdWmn87vYqp795Mht0s4
R0t9frbNytoovcOp0tw3FikvqddWe6877cDpiw5edLwarvadAr019wbYsx48bcRwt4judZphbk2cZp6
p8gdUkc338bXybjracCd13s0cWarwo6bJxu7h3NxbbanbUeeqoddVm5grycH1euf3Fwqkgab/Km5ci
/RJET_Task_4_Comp

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