Week 5 Discussion

ISSUES IN ACCOUNTING EDUCATION American Accounting Association Vol. 34, No. 2 DOI: 10.2308/iace-52375 May 2019 pp. 23–39

Who’s in Control of the Ark? A Study of Internal Controls in Operating and Auditing A Small Preschool

Elizabeth V. Grace San Jose State University

Ashley Davis The University of Oklahoma

ABSTRACT: This instructional case encourages analytical thinking about internal controls in both the operations and audit of a small, not-for-profit organization. Students examine a control environment characterized by unauthorized

expenditures, lack of documentation, and missing documents. Using the COSO (2013) framework, students

demonstrate understanding of business processes as they identify internal control risks and deficiencies, and

recommend control improvements. Auditing students additionally apply management assertions about financial

transactions and assess auditor independence. Students gain practical experience in developing flowcharts of

accounting processes and writing a management letter for a familiar organization: a preschool.

Keywords: instructional case; internal control; flowcharts; cash auditing; not-for-profit controls; auditor independence.

I. CASE

S ara Green released her seat belt and sat in her car listening to the sound of children’s laughter coming from the

Cornerstone Church. Ken Robinson, a retiree with little finance experience, served as the Cornerstone Church treasurer

and had asked Sara to perform the annual audit of the financial records of the church and its affiliated preschool, the Ark

Preschool. Sara had begun her career in assurance for a small regional accounting firm and knew the demands of performing an

audit. After several years of auditing, she returned to graduate school for an advanced degree. She now teaches accounting at a

local university and is active in several community organizations, including the Cornerstone Church. Sara served on the

church’s finance committee for five years and is familiar with its operations, but recently resigned because her evening teaching

responsibilities interfere with committee meetings.

Knowing the demands on her time, Sara hesitated to accept the pro bono audit. Ken assured her that a new, computerized bookkeeping system made record-keeping easier and offered to help her as much as needed. Sara agreed to perform the audit

and now, on a warm October afternoon, she reached into the back seat of her car for the list of audit and control questions she

prepared for the Ark Preschool director, who had been in her job for two years. Sara paused before closing the car door,

listening to children’s voices, and walked into the building. Sara’s two children had attended the Ark Preschool and she stood

for a moment in the hallway as memories washed over her. Sara remembered Thanksgiving dinners with her children dressed in

grocery bag costumes of Native Americans and Pilgrims, Mother’s Day teas with cookies made by children and teachers, and

the annual fall festivals. Startled from her reverie by slamming doors, she made her way to the preschool office.

Sara entered a tiny office crammed with three desks, computers, boxes, and supplies, and was surprised to see three

middle-aged women waiting anxiously for her. After clearing papers from the only empty seat, Sara greeted Linda Gonzalez,

the preschool director, Stacey Okada, the education administrator; and Gloria Lloyd, the office assistant. Linda and Stacey run

the preschool on a daily basis and handle tuition receipts, bill payments, crying children, worried parents, and tired teachers.

Gloria, the part-time office assistant and former engineer, primarily records transactions into an electronic system and

reconciles bank statements. Sara had asked to meet with Linda to ask a few questions about organizational goals and accounting

processes at the preschool, but all three wanted to take part in the conversation.

The authors thank the editor, associate editor, and reviewers whose comments greatly enriched this case.

Editor’s note: Accepted by Valaria P. Vendrzyk.

Submitted: February 2016 Accepted: November 2018

Published Online: January 2019

23

Sara settled into her chair and pulled out her list of questions. After briefly explaining the importance of internal controls,

she asked the staff about preschool operating, reporting, and compliance objectives. They responded that the primary operating objectives of the Ark Preschool are financial solvency, sufficient cash when needed, reduction of waste, effective scheduling of teachers to minimize overtime, and protection of preschool equipment from theft. Their financial reporting objectives include monthly budget updates, timely reconciliation of bank accounts, and reliable annual reports to Cornerstone Church. The most

important compliance objective is adherence to regulatory requirements, including wage and labor laws, federal and state income reporting regulations, and state preschool licensing requirements.

Sara listened carefully and started taking notes as Linda answered questions, while Stacey and Gloria added their

comments. Ringing telephones and teachers clocking out at the end of the day interrupted the interview, but Sara quickly

realized all three administrators were clearly invested in the preschool and were eager to explain how it worked. Sara’s notes

from the interview with Linda, Stacey, and Gloria are detailed in Table 1.

The Ark Preschool

The Ark Preschool is a not-for-profit preschool that operates as an outreach ministry of the Cornerstone Church. It opened

in 1985 when the first director saw a need for quality childcare in the community. Over time, the school adapted to meet the

needs of families who were members of the church, as well as families in the community, and expanded operations to provide

full-day childcare from infancy to school age. As an outreach ministry of the church, the preschool’s purpose is to provide

quality care and early education in a loving environment, and the preschool prides itself on its family feel. In its first ten years,

the preschool was indeed a close-knit family given that four of the teachers were the director’s daughters.

The preschool has employed several directors since 1985, but the mission has remained the same: to celebrate the spirit and

encourage the development of each child. A day at the preschool includes story time, alphabet and counting games, outdoor

play, nature walks, water play, crafts for small motor skills, music, and singing. At any time, between 60 and 75 children are

enrolled at the preschool either as full-time or part-time students. Current tuition totals $709,596 annually, an average of

$59,000 per month. With current expenses of $708,459, the preschool essentially operates in break-even mode. The largest

expenditures are for payroll and employee benefits, but the preschool also pays $3,200 per month for space shared with the

church.

As is true of many not-for-profit organizations and small businesses, the Ark Preschool maintains a small administrative

staff. In addition to the director and education administrator, the preschool employs 15 part-time and full-time teachers, a

resource specialist, and a part-time office assistant. Both the director and administrator have early childhood education

credentials and serve as substitute teachers when needed. None of the employees have backgrounds in accounting.

Linda Gonzalez is responsible for the overall management of the school, including teacher hiring and training, program

planning, community relations, and coordination with the sponsoring church. Linda meets quarterly with the preschool

advisory board, which is comprised of five parents of preschool children, one of whom is also a church member. Linda is

directly responsible to the senior minister of the Cornerstone Church and its staff-parish committee.

Stacey Okada assists the director in daily activities and is responsible for general financial oversight, reviewing and

preparing financial expenditures, deposits, and the transfer of funds between checking and savings accounts. The preschool

recently hired Gloria Lloyd, the mother of several former students, to handle record-keeping activities and bookkeeping on a

part-time basis.

The Preschool Audit

From her experience on the church finance committee, Sara knows that the Cornerstone Church has improved its control

processes over time by segregating responsibilities, requiring documentation for expenditures, and implementing strict budget

controls. She is less familiar with preschool operations and is unsure whether administrators have implemented similar

improvements. Ken Robinson told Sara about payroll errors in prior years, but the preschool recently has installed an employee

time clock and outsourced the preparation of payroll to a payroll-processing firm. Sara first examines three sets of payroll

records by recalculating hours worked, comparing her totals to payroll summaries submitted to the processor, tracing hours

calculated to processor reports, and reviewing changes to withholdings and pay rates for three sample pay periods. While there

are several miscalculations of hours worked, most of them a half-hour or less, Sara is encouraged to see that payroll summaries

generally are accurate.

Sara knows the work to complete the audit will depend on the control system present in the preschool. She must

understand transaction flows from initiation to authorization, processing, and recording in order to identify points in the

preschool’s processes where material misstatements could occur.

Thinking about the type and effectiveness of controls at the preschool, the risk of material misstatement, and the audit

procedures she would need to perform, Sara reviews her notes (see Table 1). The preschool staff answered her questions

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TABLE 1

Internal Control Interview Questions and Answers

Questions Answers

Do families receive a tuition bill? Who prepares

it? How often are families billed?

Each month Gloria ( part-time bookkeeper) prepares and emails every family a bill

that details the current month’s payment due.

Who records tuition receipts in the student

accounts?

Stacey (education administrator) prepares a list of receipts. Gloria compares list of

receipts with amounts invoiced, records payments in student accounts in

subsidiary ledger, and files the list of receipts.

How do parents pay tuition? By check? Cash?

Automated bank payments?

Most pay by check, but at least one family pays with cash.

Is tuition paid in person? By mail? Some parents mail payments, but most of them drop off payments when they bring

their children to school. If administrators are in the office, parents pay in person;

otherwise, they use the locked drop-box on the office door. Stacey or Linda

( preschool director) usually removes payments from the drop-box, but sometimes

Gloria does also.

Are receipts given? Only if a parent asks for one, but that almost never happens.

Explain the process for handling tuition

payments and deposits.

Linda endorses checks with a stamp and prepares the deposit. Stacey checks

deposits for accuracy and Linda walks the deposits to the bank, which shares the

same parking lot. Tuition is deposited on the day received, unless payment is

received after the bank closes. All undeposited cash and/or checks are kept in a

locked desk drawer. Linda deposits them when the bank reopens. Gloria records

deposits in the general ledger.

Is the fee schedule published on the internet

correct? Are any discounts given? Are they

standard for all children?

The internet fee schedule is correct. Discounts are given to siblings of current

students, employees’ children, and children of church members. Some

scholarships are given based on need, but there is no formal policy.

Is there a petty cash fund? What are its uses?

Who has access? Where is it kept?

Not exactly. Many parents don’t want to bring in separate payments for field trips or

gymnastics classes, so they are billed for these extra activities along with tuition.

Still, teachers need cash for entrance fees and gas, so we withdraw cash from the

bank in advance and hold it in a cash box we keep locked in a cabinet. Stacey

and Linda have access to the cash, usually less than $30.

Does the preschool allow any automated

withdrawals from its bank account? Is an

invoice received? Are all automated payments

for accounts in the preschool’s name?

There is only one automated payment for Yelp. We receive an email invoice but

don’t print it out. The Yelp account is in the preschool’s name.

Do you require an invoice for all payments? Are

there any exceptions?

Most of the time. We pay Don Cuesta for gym and motion classes without an

invoice. Most bills are received by mail.

Who approves payment of invoices? No one. Stacey prepares checks when invoices are received.

Who has check signing authority? Linda, Stacey, and Gloria can sign, but usually Stacey prepares and signs the

checks. Stacey marks the invoices as paid and Gloria records the disbursements.

Stacey files paid invoices.

Where are unused checks stored? In a locked desk drawer.

Describe the policy on reimbursement of

expenses. Is there a limit on dollar amounts?

Teachers and office staff should get prior approval for purchases, but there is no

formal process or form required. They usually talk with Linda for approval. There

is no limit on the amount if Linda has approved the purchase. Either Linda or

Stacey decides what budget account to be charged.

How are purchases of books, play equipment,

and supplies handled?

Linda approves and places orders. Linda also orders and approves routine purchases

of supplies such as construction paper, glue, crayons, etc. Cornerstone Board of

Trustees approves purchases of equipment.

Discuss any open accounts in the preschool’s

name.

There are only two open accounts: a teacher supply company and a grocery store.

All office staff members have cards that allow them to charge purchases at these

two stores. Purchases on open account generate a receipt, which is usually

matched against a monthly bill before payment.

(continued on next page)

Who’s in Control of the Ark? A Study of Internal Controls in Operating and Auditing a Small Preschool 25

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together, generally agreeing with responses, but sometimes correcting each other. Concerned with interview responses and

overlapping responsibilities among preschool staff, Sara draws flowcharts of preschool cash receipt and disbursement processes

detailed in Exhibits 1 and 2.

Sara turns to reconciliations of bank statements, which Gloria completes on a monthly basis. Using bank statements and

the preschool check register, Sara reconciles the December 31 cash account and finds that it agrees with Gloria’s reconciliation.

She verifies disbursements against requests for payment or a bill and documentation of expenditures by using the monthly

check register. Beginning with the January bank statement and the preschool electronic ledgers, she matches bank

disbursements and deposits with amounts recorded in the preschool records and supporting documentation. She knows the

preschool has entered into automatic payments for recurring disbursements for advertising through Yelp, an online publisher of

crowd-sourced business reviews, but frowns at several ATM payments that lack any documentation. Sara examines the check

register and supporting documentation for transactions recorded in January after the year-end close, and accounts for all check

TABLE 1 (continued)

Questions Answers

Who has preschool ATM cards? What is the

purpose of the cards? Is there a restriction on

the size of withdrawals? Is prior authorization

required?

All three staff members have their own cards, but Stacey never uses hers. Mainly

they are used to get cash for field trips, purchase supplies and food for the

children, and buy small teacher gifts. There is no restriction on the size of

transactions, but Linda approves card use in advance.

The preschool has three bank accounts:

checking, business savings, and money market

accounts. Who has authority to transfer funds

between accounts? How often are transfers

made?

Any of the office staff can transfer funds with debit cards, but only Linda and

Stacey can transfer funds online. Funds are transferred to keep only the amount

needed for disbursements in the checking account. Almost all transfers occur

online.

Is a dedicated computer used to make transfers?

Is it password protected? Are the computers

used also for email?

No. There are three computers in the office and transfers can be made on either

Linda’s computer or Stacey’s. The computers are used for email and internet

purchases also, but both of them have security software installed and are

password protected. Wi-Fi is password protected also.

Is the office door locked? Is the office left

unattended?

The door is not locked when the preschool is open. Sometimes the office is

unattended but not for very long periods of time.

Who reconciles the checking account? How

often?

Gloria reconciles the bank account each month and files the reconciliation.

What is done with checks outstanding for many

months?

There really is no formal policy.

Describe how payroll is processed. All employees, except for Linda, use a clock to record time. Stacey totals biweekly

payroll amounts, and employees review and sign their summaries. Linda reviews

the payroll numbers. Payroll amounts are sent online to ADP for processing by

either Stacey or Linda, using passwords that change periodically. ADP tracks

vacation and sick pay totals to date, writes checks, and prepares W-2 forms.

Linda documents any payroll changes using information from withholding forms.

The church Staff Parish Committee is required to authorize changes in pay rates.

After Linda and Stacey review payroll amounts from ADP, checks are disbursed

manually. Payroll records are kept in a locked file and access is controlled

somewhat.

What is the role of the preschool board? Advisory only. The Staff Parish Committee of Cornerstone Church hired Linda and

she reports directly to the senior pastor. Linda attends a weekly staff meeting with

the senior pastor.

How many weeks of vacation does each

employee receive?

Vacation is based on how long an employee has been working. The preschool

closes for one week in late August and one week between Christmas and New

Year’s. The maximum number of vacation days, in addition to these two weeks,

is three weeks.

Who handles preschool responsibilities when an

office staff member is on vacation?

All three staff members are involved in most of the management and accounting

activities. When one is absent, the others step in to handle the job. The exception

is Gloria. They generally wait for her to come back from vacation to reconcile

bank accounts.

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Issues in Accounting Education Volume 34, Number 2, 2019

numbers. She confirms year-end bank balances, and examines a cut-off statement in January. Sara lists the audit procedures she

performs, see Panel A of Table 2. She summarizes her concerns on a legal pad, presented in Panel B.

As Sara considers the system at the Ark, she remembers general principles of internal control from her experience in public

accounting:

� No employee should handle a transaction from beginning to end. � Separate cash handling from record keeping. � Centralize cash handling as much as possible. � Record cash receipts on a timely basis. � Make deposits daily. � Encourage customers to review receipts. � Make all expenditures by check or electronic funds transfer. � An employee not handling cash should prepare monthly bank reconciliations. � An appropriate administrator should review the reconciliations monthly. � Compare cash receipts and disbursements to forecasted amounts and budgets.

Using the exceptions noted, Sara begins listing cost-effective control procedures that the preschool could implement (See Table

2, Panel C).

EXHIBIT 1 Existing Case Receipts Cycle Flowchart

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She pauses, leaning back in her chair and thinking about the children, teachers, and parents at the preschool, as well as the

congregation at Cornerstone Church. She has read news reports of other schools using state funds for employee vacations,

mortgage payments, and shopping sprees. She believes the director and administrators are caring people, but Sara is concerned

about their lack of accounting and financial expertise. She worries that there is no clear definition of responsibilities. Sara is

reasonably confident that no fraudulent activity has taken place, but knows the preschool needs to implement additional

controls.

II. CASE REQUIREMENTS

(1) What are the responsibilities of the Ark management to the Cornerstone Church for cash receipts and disbursement

cycles? What are the management assertions related to cash receipt and disbursement cycles (occurrence, accuracy,

completeness, cut-off, and classification)?

(2) To whom is Sara responsible in performing the Ark Preschool audit? What are the auditor’s objectives in auditing

cash?

(3) Carefully read Sara’s interview of preschool administrators, see Table 1. Using COSO (2013), identify the principles

of effective control and associated risks that could threaten preschool objectives. See Table 3 for a template.

(4) What control improvements could reduce the risks of misstatement or fraud identified? Identify at least two

improvements, in addition to the ones already suggested, in each of the categories Sara describes in Panel C of Table 2.

EXHIBIT 2 Existing Cash Disbursements Cycle Flowchart

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(5) Recognizing that the preschool is a small business with budget constraints, write a letter to Linda Gonzalez that

identifies the control improvements you consider to be the most important in each of the following areas: authorization

controls, segregation of functions, supervision, accounting records, access controls, and independent verification. Do

not list all of the control improvements you suggested; rather, discuss those you believe would be most effective and

cost sensitive. 1

A management letter template appears in Table 4.

TABLE 2

Notes From the Ark Preschool Audit

Panel A: Procedures Followed

1. Verified disbursements against requests for payment or a bill and documentation of expenditures using the monthly check register.

2. Compared deposits, disbursements, and supporting documents with the bank statement. These tests were made for three months in the

current year, including December. Verified the primary bank checking account reconciliation for three months.

3. Examined the check register and supporting documentation for transactions recorded in January after the year-end close and accounted

for all check numbers.

4. Confirmed year-end bank balances, and examined a cut-off statement in January.

5. Checked payroll hours worked against timesheets and the payroll company statements for three payrolls.

6. Interviewed preschool administrators and flowcharted business and accounting processes.

Panel B: Control Deficiencies Identified

In general, controls are weak and Ark Preschool staff members do not consistently follow control procedures. Tests of controls identify

the following ineffective or weak controls:

1. Authorization Controls. Disbursements range from $12 to $24,000, often with no evidence of prior approval other than Cornerstone Church Trustee approval of equipment purchases. Three debit cards are available for administrator use and debit card

transactions often have no evidence of authorization. Large, unauthorized debit card purchases of gift cards are made in February

and December. In December alone, preschool administrators use debit cards for $1,410.30 of unauthorized purchases.

2. Segregation of Functions. The interview with the preschool administrators suggests multiple individuals perform the same functions.

3. Supervision. All three administrators receive tuition payments in person and two remove payments from the drop-box. One family pays tuition in cash. Deposit worksheets require two signatures, but examined deposit worksheets rarely have more than one

signature and are not double-checked.

4. Accounting Records. Documentation is often missing for disbursements by check, and some expenditures recur each month. In December, checks totaling $1,364.15 processed without any form of documentation. Both a deposit worksheet and a deposit slip for

$10,062.80 are missing in April.

5. Access Controls. The bank mails the preschool’s statements directly to the preschool, which is located beside a busy shopping center. The office door is often open, even when no one is present. Any of the staff can write checks.

6. Independent Verification. Gloria bills families and reconciles bank accounts monthly, but also makes deposits. Linda compares actual to budgeted expenditures and receipts before quarterly preschool advisory board meetings.

Panel C: Suggested Control Procedures

Control Source Suggested Procedures

Authorization Controls Enforce prior approval for employee expenditures.

Segregation of Functions No employee should handle a transaction from beginning to end.

Separate cash handling from record keeping.

Supervision An appropriate administrator should review monthly bank reconciliations.

Accounting Records Provide receipts when payment is received.

Access Controls Centralize cash handling as much as possible.

Deposit cash daily.

Independent Verification Reconcile bank accounts monthly.

1 C. May and G. May (2018) and Purdue University’s (2018) online writing assistance provide professional writing resources.

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(6 ) Using flowchart symbols provided in your text, develop a revised flowchart of the cash receipts cycle, implementing improvements suggested in Requirement 4.

2

(7) Using flowchart symbols provided in your text, develop a revised flowchart of the cash disbursements cycle, implementing improvements suggested in Requirement 4.

Additional Auditing Questions

(1) Of the control risks identified in Requirement 3, select and explain one significant deficiency and one material

weakness.

(2) Does Sara meet AICPA standards of independence? Explain.

2 KPMG (2014) provides an overview of flowcharting basics. Note that KPMG charts flow from left to right, while the ones demonstrated in this case flow from top to bottom.

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TABLE 3

COSO (2013) Principles of Effective Internal Control

Principles Application to

the Ark Preschool Risks

Control Environment

1. Is there a commitment to integrity and ethical

values?

� Mission to provide a loving family environment.

� No explicit mention of integrity by employees, but implied by

association with church.

� Many assume a faith-based group behaves ethically, but a person

intending to commit fraud may

seek it out as an easy target.

2. Is the preschool board independent from

management? Does it oversee internal control?

3. Is there oversight? Clear reporting lines of

authority?

4. Does the preschool hire, develop, and retain

competent employees?

5. Does the preschool hold individuals accountable for

internal control responsibilities?

Risk Assessment

6. Has the preschool stated objectives clearly enough

to identify risks and assess them?

7. Have risks to these objectives been identified?

8. Has the preschool considered fraud risk?

9. Has the preschool identified changes that could

impact its system of internal control?

Control Activities

10. Have control activities been selected to minimize

risks?

11. Have control activities over technology been

developed?

12. Do policies establish what is expected?

Information and Communication

13. Does the preschool use information to assess

internal control?

14. Do employees understand their roles and

responsibilities in providing financial information?

15. Do the preschool board and the senior pastor

receive information about controls?

Monitoring Activities

16. Does the preschool evaluate whether internal control

is functioning?

17. Are deficiencies reported to the preschool director,

advisory board, and Church?

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TABLE 4

Management Letter Template

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REFERENCES

Committee of Sponsoring Organizations of the Treadway Commission (COSO). 2013. Internal Control—Integrated Framework. New York, NY: AICPA.

KPMG. 2014. Better Understanding the Process through Flowcharting: An Implementation Guide. Amstelveen, The Netherlands: KPMG. Available at: https://www.execed.kpmg.com/content/PDF/Flowcharting-Implementation-Guide.pdf

May, C., and G. May. 2018. Effective Writing: A Handbook for Accountants. 11th edition. Upper Saddle River, NJ: Pearson Prentice Hall. Purdue University. 2018. Purdue Online Writing Lab. Professional Technical Writing. Available at: https://owl.purdue.edu/owl/subject_

specific_writing/professional_technical_writing/index.html

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III. CASE LEARNING OBJECTIVES AND IMPLEMENTATION GUIDANCE

Critical Thinking

One primary learning objective of this case is to foster development of critical-thinking skills in accounting students. The

AICPA (1999) and the AECC (1990) identify critical-thinking skills as a key competency needed by accounting professionals.

Business complexity, transaction speed, technology, and the global span of operations require that accountants possess not only

technical accounting ability, but also general business acumen and analytical abilities. In a study of competencies leading to

success in public accounting, Baril, Cunningham, Fordham, Gardner, and Wolcott (1998) present evidence that critical-

thinking competency is a key metric in evaluating performance of professionals.

The AICPA (1999) defines critical thinking as ‘‘the ability to link data, knowledge, and insight together from various

disciplines to provide information for decision making.’’ The National Postsecondary Education Cooperative on Assessment

(NPEC 2000) categorizes seven dimensions of critical thinking: interpretation, analysis, evaluation, inference skills, presenting

arguments, reflection skills, and dispositions. Public accounting professionals interviewed by Baril et al. (1998) include

examples of critical-thinking competencies: recognition of problem areas and need for additional information, ability to see the

big picture, ability to think ahead, and ability to transfer knowledge from one situation to another. While there is no common

definition, critical thinking generally involves the analysis and evaluation of an issue or situation in order to form a judgment or

make a recommendation.

One stream of accounting education literature examines various developmental approaches to improve critical-thinking

abilities (see Kimmel 1995; Cunningham 1996 ). Wolcott, Baril, Cunningham, Fordham, and St. Pierre (2002) summarize the

research and identify several developmental themes in common, regardless of approach: critical-thinking skills can be arranged

from less to more cognitively complex; less complex skills must be developed before higher skills can be achieved; cognitive

skills develop slowly; most college students operate at cognitive levels too low to develop critical thinking; and students need

sustained opportunities to develop critical thinking.

Another stream of accounting education literature examines teaching methods that facilitate development of critical

thinking. Pithers and Soden (2000) posit that passive learning, typified by in-class lecture and routine problem solving,

promotes memorization and the one-right-answer syndrome, while rewarding the quiet non-thinker. Young and Warren (2011)

maintain that active, experiential learning strategies are more conducive to developing critical-thinking skills. Bonner (1999)

finds learning objectives involving complex skills require teaching methods that promote active learning on the part of students.

McBride, Hannon, and Burns (2005) cite case methods as experiential teaching methodologies that are instrumental in

promoting critical-thinking skills. Other proponents of experiential learning believe it provides a context that leads to

transferable learning. For example, Sargent and Borthick (2013) find cognitive conflict enhances learning that transfers across

domains, a component of critical thinking.

Yet another stream of accounting education literature examines the effects of teaching methodology affects student

perceptions of accounting and the competencies demanded by the profession, including critical thinking. For example, Friedlan

(1995) questions whether teaching formats are associated with student perceptions of accounting careers and skills needed for

success in accounting. Students in lecture formats have negative perceptions about critical thinking and accounting, while

students using mini-cases have more positive perceptions of accounting and their expectations about careers are more in

alignment with competencies demanded in practice.

Understanding of Business Processes

A second primary learning objective of this case is to develop understanding of key business processes and the flow of

information in an organization. This understanding is vital to both managers who are operating a business and auditors who are

examining its financial records. The Sarbanes-Oxley Act of 2002 (U.S. House of Representatives 2002) requires managers and

auditors attest to the effectiveness of internal controls; Auditing Standard 2201 requires auditors understand the flow of

transactions; and, the PCAOB (2007) requires adequate documentation of internal controls in its top-down approach.

While auditors use narrative descriptions, questionnaires, and flowcharts to document business processes, Bradford,

Richtermeyer, and Roberts (2007) find an increased use of systems diagrams to document internal control and information

flows in an organization after passage of the Sarbanes-Oxley Act. PwC (2015,15) recommends enhancing student

understanding by ‘‘introducing cases with real-world concepts that students will need to understand as they enter the workplace,

such as . . . a grasp of processes and how data flows through an organization, so that they know the right questions to ask clients.’’ This current case develops competency in process documentation using document flowcharts.

This case integrates internal control and cash audit concepts and has three main features: it uses information from a real

business; it develops competency in process documentation using document flowcharts; and it facilitates broader thinking as

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students must identify deficiencies in internal control and propose control improvements. After fully investing in this case,

students in either an accounting information systems (AIS) or financial audit class should be able to:

� Describe management responsibilities for financial statements and management assertions regarding cash receipts and disbursements. (Questions 1 and 2; 10–15 minutes).

� Explain and apply COSO (2013) principles of effective internal control. (Q3; 20–30 minutes). � Analyze cash receipt and disbursement processes for control deficiencies and recommend improvements to control

procedures. (Q4; 20 minutes). � Translate descriptions of accounting processes into flowcharts or a management letter. (Q5–7; 45 minutes).

Additionally, students using this case in a financial audit class should be able to:

� Apply concepts of material weaknesses and significant deficiencies. (Q1; 10–15 minutes). � Assess auditor independence. (Q2; 10 minutes).

Intended Courses and Implementation

This field-researched case is based on interviews with the individuals mentioned in the case and data from the Ark

Preschool financial records. It concentrates on internal control issues examined in introductory AIS and information technology

audit courses. The case provides a vehicle for instructors to develop COSO (2013) principles of internal control, apply the

principles in identifying risk and control deficiencies, evaluate existing processes, and propose control improvements.

We have assigned the case in the last quarter of an AIS course to illustrate controls in revenue and expenditure cycles. It

also could be used as a course-long assignment using the first three questions as early-semester assignments on control and the

remaining questions assigned toward the end of the semester to illustrate controls over revenue and expense cycles. The case

has also been assigned in an information technology audit course as a culminating assignment, incorporating the revenue cycle,

from billing to cash collections, with the expenditure cycle. Two faculty members have taught the case in undergraduate and

graduate accounting programs at two large public universities.

The case could be used in a financial auditing class to demonstrate the audit process, from obtaining an understanding of

the client and its environment, to identification of management assertions, to assessment of client internal controls. Instructors

could use the case to evaluate Sara’s audit procedures by asking students to match each specific management assertion tested

with an audit procedure Sara followed (see Panel A of Table 2 for the audit procedures that Sara performed). Most of our

experience derives from using the case in an undergraduate AIS course, and that experience guides the following discussions.

As students complete the case questions, they progress from a basic understanding of control principles to doing more

critical thinking. For instance, students progress from simply explaining and memorizing COSO principles to identifying

financial risks arising from preschool management procedures. They then move from analyzing preschool processes to

designing more effective controls, and finally to translating their recommendations to new flowcharts.

Manager and Auditor Responsibilities

Students in an introductory AIS course often do not have an appreciation of who is responsible for an organization’s

financial statements or the role of an external auditor. Question 1 requires students to think about the purpose of financial

statements and who is responsible for them. Question 2 explores the audience for financial statements and the basic purpose of

an audit. The questions lead from a discussion of management assertions regarding cash transactions to an auditor’s

responsibility to test preschool internal controls and management assertions. Students often expect auditors to be responsible

for detecting fraud and errors in financial statements. The two questions help students to realize the roles of management in

preparing financial statements and auditors in testing assertions. The case focuses on assertions regarding cash transactions, but

instructors could expand it to include cash balances and presentation as well.

Internal Control

Case questions then lead to the analysis of internal control. At a basic level of understanding, students explain COSO

(2013) principles of internal control and identify risks present at the preschool as a response to Question 3. Students complete

Table 3 before class. We begin the classroom discussion by reviewing the operating, financial reporting, and compliance

objectives of the preschool and then have students apply each of the 17 COSO principles to the preschool and share risks that

they have identified. For a lesser time commitment and a focus on risk identification, students may receive Table 3 with the first

two columns completed and list risks to the preschool in class. Alternatively, instructors may prefer to use the five broad COSO

categories rather than the 17 principles.

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Issues in Accounting Education Volume 34, Number 2, 2019

Students demonstrate mastery of internal control principles in the remaining required case questions. In Question 4, they

identify procedures for improving control. Students often need guidance in organizing their control recommendations. For this

reason, we have organized information in the case and our suggested solution using the following categories of improvements:

authorization controls, segregation of functions, supervision, accounting records, access controls, and independent verification.

Table 2, Panel C provides examples of control deficiencies for each of the five categories, and students can add to this list of

deficiencies. Control improvements also could be organized by cash receipts and cash disbursements improvements.

Riley and Ward (2017) suggest that active learning in an AIS class is effective when students work on their own. We

complete one section (i.e., access controls of Table 2, Panel C) in class and have students complete other controls on their own.

If time permits, students share in groups for ten minutes and report their ideas to the entire class. Classroom coverage of this

question exposes students to a wide range of possible improvements to preschool processes. Asking students to identify which

preschool employee should be responsible for each proposed procedure makes control concepts more concrete. To reduce time

commitments, students may work in groups outside of class and report back to class; students may individually complete

Question 4 as a homework assignment; or, instructors may give students a completed Table 2, Panel C and assign one or more

of Questions 5–7 as a homework assignment.

Questions 5–7 are culminating questions that build upon previous case requirements. Students recommend improved

processes by either writing a management letter or drawing flowcharts of improved processes. Question 5 requires students to

draft a letter to the preschool’s management, discriminating among all the control procedures they have suggested and choosing

the most effective and cost-sensitive for the Ark Preschool. The letter template in Table 4 helps students organize their

thoughts.

Flowcharts are a visual representation of the flow of documents and information in an organization. They generally identify

the individuals or departments that handle an organization’s documents and are useful in analyzing a system for weaknesses in

internal controls and suggesting improvements. Ark Preschool is a fairly simple business with three processes: receipt of

tuition, expense payments, and payroll; however, flowcharts are somewhat difficult to draw as Gloria, Linda, and Stacey

perform many of the same functions. Questions 6 and 7 require that students recommend effective control improvements and

document the improvements in revised flowcharts.

In graduate or advanced undergraduate classes, students may review existing procedures before class, diagnose control

weaknesses during class, and flowchart revised processes to improve internal control as a graded assignment. When students

need more guidance, instructors could review existing procedures and diagnose weaknesses in class and then assign students to

work on the flowcharts for receipts and disbursements in teams during class. If time is an issue, students may prepare either the

cash receipts or cash disbursements flowchart outside of class. Alternatively, the instructor may give students both existing and

suggested flowcharts for cash receipts or disbursements. Students then identify specific differences and explain what control

deficiencies are addressed. We generally assign one of the flowcharts as a homework assignment for undergraduates and both

the cash receipts and cash disbursements flowcharts in a graduate IT audit class.

Auditing

The additional audit questions are appropriate in an IT auditing or financial auditing course. Question 1, in which students

explain one material weakness and one significant deficiency in preschool internal controls, requires development of judgment

and application of the financial reporting concept of materiality. There are numerous control deficiencies present in preschool

processes, and the challenge is to determine: (1) what the deficiencies are, (2) whether they are mitigated by compensating

controls, and (3) the severity of deficiencies. Classroom discussion may begin with a review of AICPA (2018) definitions of

material weakness and significant deficiency and the FASB (2018) definition of reasonable possibility. 3

The instructor may

provide students with a template listing control deficiencies (see Appendix A in the Teaching Notes for link) to complete in

class. As students identify compensating controls and determine whether each deficiency is significant in an auditing sense,

they connect risk identification and control procedures with the audit process.

Question 2 examines auditor independence, as students consider and apply standards of integrity, objectivity, and

independence required in the AICPA (2014) Code of Professional Conduct. This requirement produces a thoughtful discussion

of what it means to be independent in mind and in appearance.

3 AICPA AU-C 265 (AICPA 2018) and PCAOB AS 2201 (PCAOB 2007) define a material weakness as one or more deficiencies in internal control for financial reporting that lead to a reasonable possibility a misstatement of the preschool’s financial statements will not be prevented or detected and corrected on a timely basis. A significant deficiency is one or more deficiencies in internal control over financial reporting that are less severe than a material weakness but important enough to warrant attention by individuals responsible for oversight of the preschool’s financial reporting. In FASB ASC 450-20-30 (FASB 2018), reasonably possible means the chance of a future event occurring is less than likely but greater than slight.

36 Grace and Davis

Issues in Accounting Education Volume 34, Number 2, 2019

IV. FACULTY AND STUDENT FEEDBACK

This case measures effectiveness in developing critical thinking and in understanding complex business transactions in two

manners: a control/treatment test and a survey. We first measure case effectiveness by using control and treatment classes for

both graduates and undergraduates. One professor/author taught students from two sections of the graduate course, IT Audit

and Internal Control. Students received the same course materials, teaching methodology, and assignments with one exception:

one section required analysis of the Ark Preschool case and the other required a written paper. The case represented 25 percent

of student grades. At the end of the course, all students completed a validated university-wide survey using a Likert scale

ranging from 1 (strongly disagree) to 5 (strongly agree). 4

Results appear in Table 5.

Responses from students analyzing the Ark case and those writing a paper demonstrate no significant differences on two of

the three questions. Both sets of students agree the assignments enhance learning and intellectually challenging teaching

methods were used. Significant differences occur for the third question about analysis of complex and abstract ideas. The mean

response of students using the Ark Preschool case is significantly higher than the control class, and suggests the case is effective

in analyzing complex and abstract ideas.

In the first semester the same professor/author taught the Ark case as a component of an undergraduate AIS course,

students did not report significant differences on any of the three questions asked. We attribute the insignificance to two

possible factors. In the undergraduate class, the Ark case was one of many assignments and constituted a smaller percentage (10

percent) of student grades; hence, students may not have been as invested in the case as in the graduate course.

An alternative explanation is rooted in the developmental literature, which posits that critical thinking develops over time

(King and Kitchener 1994). The disparity in undergraduate and graduate student perceptions may be weak evidence of

differences in cognitive development. For undergraduates, it may not be reasonable to expect student perceptions of critical-

thinking abilities to change over the course of one semester.

In a succeeding semester, we distributed a revised survey to 22 students in an undergraduate AIS course to gather feedback

after completing the case. The survey asks students about specific outcomes, such as flowcharting ability and understanding of

controls, rather than the more general questions previously asked. Table 6 details survey questions and student responses.

Students most strongly agree that their flowcharting skills improved with the case. They agree that the case is useful in

understanding both control issues and the issues auditors face in a real entity. Students agree that the case is understandable,

even for those with no background in not-for-profit accounting. While students are not as enthusiastic about writing a

management letter, they agree that the case is a beneficial learning experience. We subsequently added the management letter

template to help students in drafting their letters.

TABLE 5

Student Survey Responses Differences in Means Tests

Question

With Case: Mean Response

(Number of Students)

Without Case: Mean Response

(Number of Students)

t-statistic (Probability)

Graduate Students

This course used assignments that enhanced learning. 4.2174 3.9231 0.8631

(30) (17) (0.3941)

The course used intellectually challenging teaching methods. 4.1739 3.6154 1.4417

(30) (17) (0.1585)

The course helped students analyze complex and abstract ideas. 4.0870 3.4167 2.7227

(30) (16) (0.0103)

Undergraduate Students

This course used assignments that enhanced learning. 3.9302 3.7656 1.4559

(43) (64) (0.148)

The course used intellectually challenging teaching methods. 4.1501 3.9206 1.2167

(44) (63) (0.2264)

The course helped students analyze complex and abstract ideas. 4.1163 3.8413 0.7673

(43) (63) (0.4446)

4 The survey is the Student Opinion of Teaching Effectiveness administered and validated for all courses at the primary university.

Who’s in Control of the Ark? A Study of Internal Controls in Operating and Auditing a Small Preschool 37

Issues in Accounting Education Volume 34, Number 2, 2019

For confirmation of results, a teacher/author taught the case at a second large, public university. Student responses to this

survey (n ¼ 119) appear in Table 6 and largely confirm student evaluations in the original test. Students agree that: their flowcharting skills improve, the case is useful in understanding control issues and issues auditors face, and the case is a

beneficial learning experience. Students in the confirmation sample differ by finding the letter assignment more valuable, but

are less positive the case helped understand auditor independence. We believe these differences result from the addition of the

letter template and from different instructors teaching the case.

TEACHING NOTES AND STUDENT VERSION OF THE CASE

Teaching Notes and the Student Version of the Case are available only to non-student-member subscribers to Issues in Accounting Education through the American Accounting Association’s electronic publications system at http://aaapubs.org/. Non-student-member subscribers should use their usernames and passwords for entry into the system where the Teaching Notes

can be reviewed and printed. The ‘‘Student Version of the Case’’ is available as a supplemental file that is posted with the Teaching Notes. Please do not make the Teaching Notes available to students or post them on websites.

If you are a non-student-member of AAA with a subscription to Issues in Accounting Education and have any trouble accessing this material, please contact the AAA headquarters office at [email protected] or (941) 921-7747.

REFERENCES

Accounting Education Change Commission (AECC). 1990. Position Statement Number One: Objectives of Education for Accountants. Sarasota, FL: American Accounting Association. Available at: http://www2.aaahq.org/aecc/pdf/position/pos1.pdf

American Institute of Certified Public Accountants (AICPA). 1999. AICPA Core Competency Framework for Entry into the Accounting Profession. Durham, NC: AICPA. Available at: https://www.aicpa.org/interestareas/accountingeducation/resources/ corecompetency.html

American Institute of Certified Public Accountants (AICPA). 2014. Code of Professional Conduct. Durham, NC: AICPA. American Institute of Certified Public Accountants (AICPA). 2018. Communicating Internal Control Related Matters Identified in an

Audit. AU-C Section 265. Durham, NC: AICPA.

TABLE 6

Survey of Undergraduate Accounting Information Systems Studentsa

Question

University 1 Mean

(Std. Dev.)

University 2 Mean

(Std. Dev.)

I found the case interesting. 4.20 4.08

(0.91) (0.72)

I found the case to be useful because it involves control issues within a real entity. 4.33 4.41

(0.87) (0.56 )

The case was understandable even though I have not had a not-for-profit accounting class. 4.27 4.10

(0.85) (0.76 )

The case provided real-world applicability of what I learned in class about the components of an entity’s

internal control.

4.27 4.44

(0.93) (0.59)

The case provided real-world applicability of what I learned in class about flowcharting. 4.60 4.24

(0.49) (0.63)

The case helped me understand the type of real-world issues faced by auditors. 4.33 4.28

(0.87) (0.71)

The case provided real-world applicability of what I know about auditor independence. 4.13 3.80

(1.14) (0.84)

The case provided a good opportunity to practice writing a management letter. 3.80 4.11

(1.22) (0.75)

Overall, the case provided a beneficial learning experience. 4.07 4.35

(1.06 ) (0.57)

n 22 119

a Please circle the number that corresponds with how strongly you agree or disagree with each statement. 5¼strongly agree; 4¼agree; 3¼neither agree nor disagree; 2 ¼ disagree; 1 ¼ strongly disagree.

38 Grace and Davis

Issues in Accounting Education Volume 34, Number 2, 2019

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