Chap#4 Internal Control

Meaning of Internal Control

 Internal control means the whole system of controls employed by the
management in order to carry on the business of the company more efficiently,
safeguard its assets and secure, as far as possible the accuracy and reliability of
its records.
 The “term internal control system” means all the policies and procedures
(internal controls) adopted by the management of an entity to assist in
achieving management’s objectives of ensuring, as far as practicable, the
orderly and efficient conduct of its business, including adherence to
management policies, the safeguarding of assets, the prevention and detection
of fraud and error, the accuracy and completeness of the accounting records,
and the timely preparation of reliable financial information. The internal
control system extends beyond those matters which relate directly to the
functions of the accounting system and comprises:
 “The control environment” which means the overall attitude, awareness and
actions of directors and management regarding the internal control system and
its importance in the entity. Factors reflected in the control environment
include:
 The function of the board of directors and its committees.
 Management’s philosophy and operating style.
 The entity’s organizational structure and methods of assigning authority and
responsibility.
 Management’s control system including the internal audit function, personnel policies
and procedures and segregation of duties.

 “Control Procedures” which means those policies and procedures in addition to the
control environment which management has established to achieve the entity’s specific
objectives. Specific control procedures include:
 Reporting, reviewing and approving reconciliations.
 Checking the arithmetical accuracy of the records.
 Controlling applications and environment of computer information system, for example:
by establishing controls over:
 Changes to computer programs
 Access to data files
 Maintaining and reviewing control accounts and trial balances.
 Approving and controlling of documents.
 Comparing internal data with external sources of information.
 Comparing the results of cash, security and inventory accounts with accounting records.
Categories of Internal Control
 Internal control can be divided into two categories: (1) Financial control and
(2) Management control
Financial Control
 This category of internal control is mainly concerned with legitimacy of expenditure and
income and security of assets, the main areas of this category of internal control are as under:
Budgetary Control
 The entity should plan and control its expenditure and income to meet its predetermined
objectives. 
Legitimacy of Income and expenditure
 All income and expenditure should be properly authorized and should be in accordance with
the policies and laws.
Accounting Control
 Transactions are recorded as necessary to permit preparation of financial statements in
conformity with generally accepted accounting principles or any other criteria applicable to
such statements and to maintain accountability for assets;
 Access to assets is permitted only in accordance with the management’s authorization:
 The recorded accountability for assets is compared with the existing assets at reasonable
interval:
 Transactions are extended in accordance with the management’s general or specific
authorization.
Management or Operational Control
 The objectives of these controls are to promote operational efficiency and encourage adherence
to managerial policies. The following are basic control areas:
 Objectives
 The organization should regularly review its objectives relating to operational activities and
determine the methods needed to achieve them. It is the responsibility of management to
determine objectives, policies and plans.
Organizational Procedures
 All the staff and officers should be informed about the objectives and organizational
procedures, so that they can easily achieve the operational activity.
Organizational Structure
 The organizational structure should be clearly defined so that all officers and staff can
understand their role and responsibilities and carry out their jobs more efficiently.
Management Information
 Management must be informed regularly with regard to up-to-date data of the financial and
operational performance of all business activities.
Proper Supervision
 Proper systems of supervision i.e., division of duties, independent checking of work, quality
control etc., should be maintained to ensure that fraud or errors within the operation are
discovered before it is too late.
Review of Operational Efficiency
 Management should review the efficiency of the organization on regular basis, so that any
change can be made in the operation according to changing circumstances.
The Need of Internal Control
 In case of small business, the numbers of transactions and members of staff are few and
as such it is very easy to impose close supervision over all business activities for an
individual.
 But in case of companies the volume of work is so great and of varied nature that it is
beyond the capacity and control of any one individual.
 In these circumstances, it becomes essential to delegate responsibility, and if the same
strict supervision is to be continued, reliance must be placed, in the main, upon members
of the staff themselves.
 It is therefore, an adequate internal control is established by the management in order to
carry on the business of the company in any orderly manner, safeguard its assets and
secure as far as possible the accuracy and reliability of its records.
Inherent limitation
 An internal control system cannot be considered to be completely effective, regardless of
the care followed in its design and implementation.
 Even if systems personnel could design an ideal system, its effectiveness depends on the
competency and dependability of the people using it. For example: assume that a
procedure for counting inventory is developed and requires two employees to count
independently. If both of employees are careless in doing the counts and do not follow
the instructions, the count of the inventory is likely to be wrong. Even if the count is
right, the management might override the procedure and instruct an employee to
increase the count of quantities in order to improve reported earning. Similarly, the
employees might decide to overstate the counts intentionally to cover up a theft by both
of them.
 Due to these case inherent limitations of controls, the auditor must obtain audit evidence
beyond testing the control for every material financial statement count.
Responsibility of Management
 It is the main responsibility of the management to establish and maintain an adequate
internal control system within the organization. It is therefore, the management and not
the auditor are responsible to prepare financial statements in accordance with generally
accepted accounting principles.
Reasonable Assurance
 An organization must establish an internal control system that gives reasonable
assurance that the financial statements are fairly stated. Internal control structures are
generally developed by the management with due consideration of the cost and benefits.
In view of this, the management usually established such internal control system which is
less expensive.
Principles of Internal Control
 The basic principles of financial internal control are explained below:
 Financial and accounting operations must be separated, i.e., the handling of cash and the
recording of the movement therefore should be done by different persons.
Responsibility for the performance of the job must be clearly stated so that there may be
no room for doubt or confusion subsequently.

Too much confidence should not be pinned in one individual. Nearly all frauds have been
committed by ‘trusted’ officials or employees. It is interesting to note that frauds have
occurred owing to their being trusted.

 Rotation principle relating to transfer of an employee from one job to another should be
the inflexible guiding rule. This is an effective safeguard against collusion and is
recognized as an important canon of sound organization.
Mechanization of the work wherever feasible and practicable, should be resorted to
mechanical devices such as cash register, recording time clocks, calculation machines
etc., should be introduced.
The work should be so arranged that work done by one employee should be promptly
checked by another independent employee. Such continuous and constant checking
goods, moral control and the errors and the fraud cannot go undetected.
Clear and well defined rules should be laid down and practically followed relating to
dealing of the cash, ordering, receiving and issuing goods etc. instructions should be
in writing in the form of accounting manuals.
Employees must be in bond so that the tempted employee must be deterred from
committing fraud and employer be protected.
Although not a substitute for protective financial internal control, yet double entry
system of accounting must be used.
Some of the examples of internal controls are as under:
(1) Physical Clock cards, cash registers, etc.
(2) Mechanical Invoice typewriter, tabulating and computer machines.
(3) Theoretical Work of one employee is to be checked by another,
cashier abstaining from making entries in the ledgers etc.
 
Review and reliance on internal control by the auditor
 Before starting the audit, the auditor should review the system of internal control for the
following consideration:
 To examine the weakness of system, if any.
 To consider the proposition of introducing test check to be performed during the course
of audit.
 Based upon above (i) and (ii), determine exactly the extent of work to be performed so as
to enable the auditor to express his opinion on the given set of accounts.
 A proper and effective system of internal control offers advantages such as; saving of time
for the auditor, reduction in cost of conducting audit and assurance to auditor of the
reliability of the financial accounts. To what extent should an auditor depend upon the
system will depend upon the circumstances of each particular case and the efficiency of
the audit will depend upon the skill, tact, experience and, above all, the judgment of the
auditor.
  System of Internal Control
 Systems of internal control in respect of small and manufacturing concerns and other
aspects of business are explained below:
 A: Small Concerns
 Correspondence
 All incoming correspondence should be opened by a responsible official.
  Remittances and Deposits
 All remittances in the form of check drafts etc. should be crossed and marked “Accounts
Payee only” and deposited into the bank on the next day.
  Payment Authorization
 All payments should be sanctioned by responsible officials
Wages and Salaries
 Wages and salaries sheets/book should be carefully checked and payments made in the
presence of persons knowing the laborer's and clerks.
Goods
 A complete record of all goods received and sent out should be maintained and physical count
should be carried out at regular intervals.
B: Manufacturing Concerns
Access to Ledgers
 The cashier should have no access to the ledgers and the ledger-keepers should not maintain
the books of original entry.
Correspondence
 All correspondence receive should be daily opened by a responsible official.
Remittances
 All remittances received in the form of checks, drafts, etc., should be cross marked “Accounts
Payee only”, entered into a cash diary and handed over to the cashier.
Deposit
 All receipts should be banked daily or on the next day and a periodical bank reconciliation
should be prepared.
Printed Form
 Official printed pre-numbered forms should be used for issue of receipts and signed by a
responsible official. Unused stock of receipt books should be kept under lock and key.
Cash Sales: Cash sales should be adequately supervised.
Payment Authorization
 As far as possible, all payments should be made by crossed check marked “ Accounts
Payee only”.
Wages Payments of wages should be carefully supervised.
Purchases
 Purchases should be subject to proper control and all inward invoices should be checked.
Credit Notes
 Credit notes for returns, allowances and bad debts written off should be authorized by a
responsible official. 
Mechanical Appliances: As far as possible, mechanical appliances should be used.
Stock and Stores
 Periodical physical check should be carried out by a responsible official.
Cash Receipts
Receipt Books
 The following inflexible rules should be followed as a sound system of internal check.
 Unused books should be kept under lock and key.
 All receipts should be consecutively numbered.
 The issue and custody of cash receipts should be under the control of the responsible
officials.
 Originals of all spoilt and cancelled receipts should be retained and countersigned by a
responsible official.
Acknowledgement: For every amount received, official receipt must be issued.
 Deposits : All collections must be internally checked and then deposited into the bank in tact
the next day. Pay-in-slips should be filed and checked daily. The amount should then be traced
into the bank statements. All outstanding collections should be thoroughly scrutinized and steps
should be taken to obtain a credit for the same. Collection of overdue balances should be attended
to.
No Access to Ledgers: The cashier should not be allowed any access to personal or general
ledgers.
Physical Count: Surprise inspection of cash should be done by a responsible official.
Segregation: All collections must be segregated and kept separate.
Cash Payments
 Mode of Payments
 As far as possible, payments must be made by crossed checks marked “Accounts Payee only”
and official receipts should be obtained.
Recording
 All payments should be promptly recorded in the cash book.
Vouchers
 All supporting vouchers of payment should be serially numbered and filed in order to facilitate
the subsequent checking by the auditors.
General
 Arithmetic Accuracy: casts, cross casts and carry forward of all amounts in the cash book
should be checked.
 Bank Reconciliation: Periodical bank reconciliation statements should be prepared. Bank
confirmation should be prepared. Bank confirmations should be obtained and all outstanding
items should be carefully scrutinized.
Purchases
Initiation of Purchase
 There should be established limits for order level, minimum level and
maximum level of stores and stocks to serve as a basis on which the storekeeper
should, after following these limits, send material purchase requisitions to
enable the purchase department to initiate purchase.
Quotations and Tender
 Quotations or tenders should be called and decision made to buy from a
certain seller. The guiding factor should be to buy at most economic price.
Placing Order
 An order for the purchase should then be sanctioned asking the buyer to supply
goods within a stipulated time. All copies of purchase orders should be
consecutively numbered and filed. These should then be entered into the
purchase order register.
Sales
Orders Received
 An attempt must be made to obtain orders in writing. Confirmations in writing
should be obtained in respect of verbal orders. All orders received should be
entered in the Orders Received Book.
Execution of Orders
 The orders should then be executed with the desired time and marked off from
the orders received book.
Invoice
 Desired number of the copies of invoice should be prepared and internally
checked. In case of contracts sales, original contracts should be studied and
basis of billings should be verified. A part from this, a responsible official
should mark the rate at which goods are to be invoiced.
Dispatch of Goods
 All goods dispatched should be recorded in the Goods Dispatch Register. All
quantitative movement shown on sales invoices should be traced into the
above register.
Receipt of Money
 A careful watch over the collection of money against credit sale should be kept
and such a system should be installed whereby recoveries of amounts are being
made regularly.
Goods Returned
 All goods returned by customers should be entered in the goods inward book
and a credit note should be passed by a responsible official and prepared in
duplicate for each return of goods or allowance granted.
Access to Ledgers
 The person making the sale should have nothing to do with the office where
sales ledgers are posted up, nor with the cashier’s office where the check in
payment of customer’s accounts are received.