Question - Preview Company, a diversified manufacturer, has five divisions that operate throughout the US and Mexico. Preview has historically allowed its divisions to operate autonomously. Corporate intervention occurred only when planned results were not met. Corporate management has high integrity, but the board of directors and audit committee are not very active. Preview has a policy of hiring competent people. The company has a code of conduct, but there is little monitoring of compliance by employees. Management is fairly conservative in terms of accounting principles and practices, but employee compensation packages depend highly on performance. Preview does not have an internal audit department, and relies on the audit firm you work for to review the controls in each division.

Chip Harris is the general manager of the Fabricator Division (FD). The FD produces a variety of standardized parts for small appliances. Harris has been the general manager for the last seven years, and each year he has been able to improve the profitability of the division. He is compensated based largely on the division's profitability. Much of the improvement in profitability has come through aggressive cost cutting, including a substantial reduction in control activities over inventory.

During the last year, a new competitor las entered FD's market and has offered substantial price reductions in order to grab market share. Harris has responded to the competitor's actions by matching the price cuts in the hope of maintaining market share. Harris is very concerned because he cannot see any other areas where costs can be reduced so that the division's growth and profitability can be maintained. If profitability falls, his salary and bonus will be reduced.

Harris has decided that one way to make the division more profitable is to manipulate the inventory because it represents a large amount of FD's balance sheet. He also knows that controls over inventory are weak. He views this inventory manipulation as a short-run solution to the profit decline due to the competitor's price cutting. Harris is certain that once the competitor stops cutting prices or goes bankrupt, the misstatements can be corrected with little impact on the bottom line.

Required:

1. Evaluate the strengths and weaknesses of Preview Company's control environment.

2. What factors in that environment have led to and facilitated Harris' manipulation of inventory?