BCom 3rd Year Internal Control and Internal Check in Auditing Notes Study Material
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BCom 3rd Year Internal Control and Internal Check in Auditing Notes Study Material
“Internal control has been defined as being “not only internal check and into audit but the whole system of controls, financial and otherwise established h management in order to carry on the business of the company in an orderly man safeguard its assets and secure as far as possible the accuracy and reliability of its records.”
“Internal control is best regarded as indicating the whole system of controls, financial and otherwise, established by the management in the conduct of a business, including internal check, internal audit and other forms of control.” -W. W. Bigg
“Internal control comprises the plan of organization and all of the co-ordinate methods and measures adopted within a business to safeguard its assets, check the accuracy and reliability of its accounting data, promote operational efficiency, and encourage adherence to prescribed managerial policies.” -American Institute of CPAs (1948)
But, now, the definition has been revised and divided into two parts-Administrative Controls and Accounting Controls as given below:
Administrative Control includes, but is not limited to, the plan of organization and the procedures and records that are concerned with the decision processes leading to management’s authorization of transactions. Such authorization is a management function directly associated with the responsibility for achieving the objectives of the organization and is the starting point for establishing accounting control of transactions. (BCom 3rd Year Internal Control and Internal Check in Auditing Notes Study Material)
Accounting Control comprises the plan of organization and the procedures and records that are concerned with the safeguarding of assets and the reliability of financial records and consequently are designed to provide reasonable assurance that :
(a) Transactions are executed in accordance with management’s general or specific authorization.
(b) Transactions are recorded as necessary (1) to permit preparation of financial statements in conformity with generally accepted accounting principles or any other criteria applicable to such statements and (2) to maintain accountability for assets.
(c) Access to assets is permitted in accordance with management’s authorization.
(d) The recorded accountability for assets is compared with the existing assets at reasonable intervals and appropriate action is taken with respect to any difference.
From the above definitions, it would be evident that internal control is a broad term with a wide coverage. It means a number of checks and controls exercised in a business to ensure its efficient and economic working.
This, internal control involves a sort of vigilance and direction over important matters like budget and finance, purchases and sales and internal administration by the management: for example, in case of proprietary concern, such a control would be exercised by the proprietor while in the case of partnership firm and a joint stock company, it would come from the acting partners and directors respectively.
Thus, it may be stated that a system of internal control provides a measure for the management to obtain information, protection and control which are quite important for the successful working of a business organization.
Every business enterprise is expected to have a properly developed system of internal control which may include accounts control, standard of cost control, budgetary control, periodic operating reports, statistical analysis, personnel training programme and an internal audit staff. It may also include other activities such as time and motion studies and quality controls through inspection.
Various other forms of administrative checks and controls are sometimes included in the internal control system. In short, it can be said that a system of internal control includes all those measures adopted by a business enterprise to fulfill the following objectives :
- To avoid waste, inefficiency and fraud and to keep intact its resources:
2 To attain highest type of accuracy and reliability in the maintaining of the accounts and operating data;
- To encourage and measure how far the policy of the business is being implemented;
- To evaluate the efficiency of performance in all aspects of business activity, and
- To provide aid in management planning.
Characteristics of Good Internal Control
- There should be a well-developed plan of organization with delegation of proper responsibilities at various levels of operational hierarchy.
- There should be a scientifically developed system of record procedures with a view to maintain proper controls over capital and revenue organization.
- A system of healthy practices and traditions is also necessary for the performance of duties and activities of various departments of the organization.
- The personnel engaged in the business should be of high quality and character with a thorough understanding of their responsibilities and a proper background of training and ability. After all, controls are exercised by the personnel engaged in the business and qualified people can better make use of such controls. (BCom 3rd Year Internal Control and Internal Check in Auditing Notes Study Material)
Divisions of Internal Control
Every business enterprise is expected to have well-knit organization of internal control system. Much depends upon the nature of business and the environments in which it works. The main divisions of an overall internal control system cover: (a) general financial control: (b) cash control; (c) employees’ remuneration; (d) trading transactions: (e) stock maintenance: (f) fixed assets; and (g) investments. The particular aspects of each must be considered by management when planning the allocation and distribution of among its employees. These divisions are briefly discussed below:
(a) General Financial Control. This control includes a proper efficient system of accounting, adequate supervision, recording and duplicating system, good efficient staff and maintenance of staff relationships. Under this system, an adequate system of flow of information to the management should be developed through returns and statements submitted by the supervising staff.
Healthy staff relations should be maintained so as to ensure more efficient and effective working. It is true that due to the lack of harmonious staff relationships, staff may leave for better prospects elsewhere and thus, impair the working of the system. Staff turnover is injurious from the viewpoint of general financial control and hence, adequate stress should be laid on their proper maintenance.
(b) Cash Control. This system includes certain important aspects of control for receipts, payments and balances held. A proper system of internal check must operate at all stages. There may be specially deputed officials including the internal audit staff who should be made responsible to exercise checks at regular and irregular intervals. Due safeguards should be exercised to avoid misappropriation of cash.
There are other aspects of control of funds and payments. Specific instructions should be given to all the staff in writing in this regard. As for payments, the system of payment by cheques is the best at all times and at all levels of business. At this stage also there should be proper allocation of duties. (BCom 3rd Year Internal Control and Internal Check in Auditing Notes Study Material)
(c) Employees’ Remuneration. There have been many cases of defalcation and misappropriation of cash payments to be made to the employees. The system must cover all sections of employees’ remuneration and maintenance of records for remuneration their preparation and their methods of payment should be brought under tight control. This further requires issue of specific instructions to the staff in writing engaged in the various processes of work connected with the employees’ remuneration.
(d) Trading Transactions. These transactions pertain to the purchases, sales, etc. In regard to purchases, effective procedures should be laid down for acquisition, handling of goods and for accounting technique adopted for such goods. Similarly, a good system of procedures should be devised for authorization, recording, handling and accounting of goods sold. The weaknesses, if any, might lead to a great loss to the business and hence, the entire system of control should be kept strictly under regular review and constant check.
(e) Stock Maintenance. Stocks of raw materials, work-in-progress and finished goods should be properly maintained and accounted for. The flow of goods from outside to the store and again, from the store to the processing part and vice-versa should be made under an efficient control and supervision. The tasks and responsibilities connected therewith should be clearly defined and fully allocated. Regular stock-taking procedures are quite helpful as means of independent checks and reconciliation of records.
(f) Fixed Assets. Capital expenditure on fixed assets should be kept under strict check and supervision. The authority right from sanctioning of capital expenditure to its use should be clearly defined so that any sort of misappropriation by officials of the organization can be reduced to the minimum. There may be cases of collusion with the contracter and proper safeguards should be exercised at all stages.
(g) Investments. The procedures of control in regard to investments cover such measures as authorization, recording of all transactions including the maintenance of records of investments held and safeguarding of documents of title. The whole system of control requires that written instructions should be issued to enforce rigidly the procedure of internal control.
Internal Control and Auditor
The introduction of a well-developed system of internal control is the responsibility he management. But it is a matter of concern for the auditor though he has no authority to recommend and prove that certain rules and procedures should be adopted by the business. He can simply guide and help if he is required to do so. (BCom 3rd Year Internal Control and Internal Check in Auditing Notes Study Material)
What is expected from him is that he must possess expert knowledge of such procedures. In the second standard of fieldwork set out by the AICPA, it is made clear that “there is to be a proper study and evaluation of the existing internal control as a basis for reliance thereon and for the determination of the resultant extent of the tests to which auditing procedures are restricted.”
Thus, the aim behind the study of internal control by an audio establish a basis for reliance on the system of this control so as to enable him to assess extent to which he should apply tests during the course of audit.
This is much certain that if there is a good system of internal control, the work of an auditor becomes quite easy. He can very conveniently rely on test checking. However, it depends upon special circumstances of a particular case as to how far internal control would be helpful in the audit work. The following points would be helpful in screening the internal control system:
- Study of accounting routine, its weaknesses and sources from which they would arise;
2 Financial powers vested in the various officials and the circumstances in which they are to be used;
- Study of limits of inspection over financial and other accounting duties;
- Whether some mechanical appliances are used to prevent any defalcation of cash, etc.; and
- Whether any device of checks and balances is used to measure the success of accounting methods of techniques.
The auditor can be in a position to perform audit efficiently provided that there is a good and effective internal control system in use. However, it does not mean that he can take shelter under the system and shirk to his duties. The entire responsibility is his and there is nothing to protect him if he does his work carelessly and with negligence.
It is to be noted in this connection that the audit should impose the most rigorous possible examination on the systems of internal control and should cover every aspect of the administration from the purchasing procedure to the control of sales invoices and dispatch of goods. For this, the work of audit should be arranged in such a way that the system is checked at the same time when the books and records are verified.
Under the provisions of the Manufacturing and Other Companies (Auditor’s Report) Order, 1988, it is now obligatory for a company auditor to ensure that there is an adequate internal control procedure commensurate with the size of the company and the nature of its business, for the purchase of stores, raw materials including components, plant and machinery, equipments and other assets, and for the sale of goods.
Basic Principles of Internal Control
There are certain organizational devices which are considered important as basic Principles of internal control system. It is to be noted that:
(1) Practically the physical handling of an asset should be separated from the accounting work which should be done by a separate hand. The collusion between a person handling an asset and another performing accounting work in relation thereto should be avoided.
(2) The work should be so divided between persons that the work done by one is checked by another.
Thus, the result expected from the work done and the check thereof can form a basic for reliability of records and reports maintained in the business. This practice is sound in the sense that what one does can be compared well with the results obtained by another.
Internal Control Questionnaire (I.C.Q.)
The internal control questionnaire (I.C.Q.) is a series or questions which are prepared by the auditor to test the adequacy or otherwise of the system of internal control adopted in an organization. Such a questionnaire can be used by the auditor for all clients, small of big, and it varies according to the requirements of each client. (BCom 3rd Year Internal Control and Internal Check in Auditing Notes Study Material)
I.C.Q. should contain sets of questions for different transactions in a business-house and the answers to the questions contained in I.C.Q. will provide a clue for an auditor to judge the adequacy or otherwise of the system. In other words, if the answers are positive, the system of control would be deemed to be satisfactory. If otherwise, i.e., the answers being negative, the system would be presumed to be inadequate. However, much will depend upon enquiries or further enquiries to arrive at a right decision about adequacy or otherwise of the system.
It is evident that an auditor can use short-cut methods at his own risk, of course, such as test checks or random sampling. It is his own discretion and nobody can question it. But such an I.C.Q. with full observations should be kept by the auditor in his permanent file for future reference. (BCom 3rd Year Internal Control and Internal Check in Auditing Notes Study Material)
The following points should be noted by an auditor while making use of internal control questionnaire:
- The I.C.Q. should be revised and reviewed every year so as to make it more effective and up-to-date. This is very necessary because there may be questions which have become out of date due to changes which have been brought about in the working of the organization.
- The efforts should be directed towards making the questionnaire complete in all respects. There might be changes in the economic and commercial laws and also due to legal requirements for which a revision of questions given in the I.C.Q. would be necessary. Such changes should be made regularly. (BCom 3rd Year Internal Control and Internal Check in Auditing Notes Study Material)
- The I.C.Q. also helps the auditor to advance some good and valid suggestions to the client from time to time. It is certain that the answers to the questions in the I.C.Q. would reveal some concrete weaknesses in the system and on their basis, suggestions can be given to the client so as to enable him to improve the working of the organization and make it more effective.
- The I.C.Q. has got a close relationship with the audit programme. An auditor can prepare a detailed audit programme if he finds that the internal control system is defective and the working of the organization is faulty. He can also rely on the system to a reasonable extent depending upon the positive or negative answers to the questions given in the internal control questionnaire.
In business-houses, the work connected with the preparation and maintenance of accounts is distributed amongst the various members of the staff in accordance with their distinctive qualifications. One person enters transactions in the books, while others form tasks relating to posting, handling cash and entering cash transactions into the Cash Book. Besides these, duties pertaining to writing up Purchases Book and its postings are not entrusted to a single person. These are some of the examples which substantiate argument that different duties are assigned to different hands. (BCom 3rd Year Internal Control and Internal Check in Auditing Notes Study Material)
The reason is quite simple. If only one person is made responsible to finish up a particular work from the beginning to the end, there is enough scope for errors and fraud creeping into the books of accounts. The possibility of frauds can arise only when there is a collusion between the clerks. Such situations will have to be avoided to ensure a clean and efficient recording of business transactions.
Besides this, it is also kept in mind at the time of distributing the work that changes should be made in the assignments and responsibilities as and when needed. By doing so the work of one person is automatically checked by another and errors, fraud and irregularities can easily be detected. The result is that the efficiency of the business increases in the long-run.
This is a system of internal check which is based on the principle of division of labour. It is certain that if the system of internal check is good and efficient, the possibility of errors or fraud or irregularity will be minimized and the business can enjoy the benefit of division of labour and of specialization also. (BCom 3rd Year Internal Control and Internal Check in Auditing Notes Study Material)
De Paula has rightly said that “an internal check means practically a continuous internal audit carried on by the staff itself by means of which the work of each individual is independently checked by other members of the staff.” The system provides for an independent and automatic scrutiny along with the work assignment. The method involves mainly four things, viz :
(i) That the work is properly divided in such a way that all the duties are assigned to different clerks.
(ii) That the clerks get the work-load according to their capacities and qualifications.
(iii) That one person does not perform any single task from the beginning to the end.
(iv) That the work done by one clerk is checked independently and automatically by another.
For example, if in a big business the number of labourers is large and six clerks are needed to maintain records of their attendance, to prepare Wage Sheets and to make payment of wages, ie., two clerks to perform the job connected with each of these three functions. Thus, two persons are made responsible separately for doing the job connected with such of the three functions in regard to wage payment.
There may be two ways of doing it:
(i) either one-third of the work connected with all the three portions of work relating to wages may be performed by two persons; or
(ii) for every portion of this work, i.e., maintenance of wage records, preparation of Wage Sheets, and the payment of wages, two persons may be made responsible.
It means that two clerks should maintain records, another set of two clerks should prepare Wage Sheets and the remaining two clerks should arrange for the payment of wages. (BCom 3rd Year Internal Control and Internal Check in Auditing Notes Study Material)
Out of these two arrangements quoted above, the first one is defective as it provides scope of collusion between two persons when they have to perform one-third portion of the work from the beginning to the end. They can adopt malpractices and commit irregularities by showing dummy names of workers in the Wage Sheets or by making extra payment to the workers for the time which they have not devoted to the business or for in work they have not done. (BCom 3rd Year Internal Control and Internal Check in Auditing Notes Study Material)
But the second device is more reliable and efficient as in this case the whole of work is suitably and rationally divided and there is no possibility for fraud as the involved in each portion can be checked by the clerks. The whole arrangement is m in such a way that the work and its checking are carried on independently. The division of work on this basis is known as a system of internal check.
Hence, internal check is an arrangement of duties in a business done in such a w that all the duties connected with the accounting work are properly allocated so that one person may not be in a position to pursue single job from the beginning to the end and along with this, the work of one person may be checked automatically and independently by another.
Objects of Internal Check
(1) To allocate duties and responsibilities of every clerk in such a way that he may be held responsible for a particular error or fraud;
(2) To minimize the possibilities of errors, fraud or irregularities;
(3) To detect errors or fraud easily if it is committed, as in an efficient system of internal check there is provision for independent checking;
(4) To enhance the efficiency of clerks in a business as the assignment of duties is based on the principle of division of labour;
(5) To distribute work in such a way that no business transaction is left from recording:
(6) To prepare final accounts with ease and efficiency as an efficient system of internal check can make accounts more regular and reliable; and
(7) To exercise moral pressure over staff.
Internal Check and Internal Audit
There is a lot of difference between internal check and internal audit. In internal audit, a batch of employees known as internal auditors is engaged to check the records of day-to-day transactions while in internal check, the work and its checking go together.
Points of Distinction
(1) Internal check is an arrangement of duties allocated in such a way that the work of one clerk is automatically checked by another while internal audit is an independent review of operations and records undertaken by the staff specially appointed for the purpose.
(2) In internal audit, a separate salaried staff of internal auditors is engaged to carry on the independent appraisal of activities within a business. Their job is to audit the financial records and operations from time to time. But in internal check, there is no separate staff appointed especially for this purpose. Different clerks of a business are allocated their assignments with which they proceed and carry on checking at the same time. (BCom 3rd Year Internal Control and Internal Check in Auditing Notes Study Material)
(3) In internal audit the work of a clerk is checked by an internal auditor after the former has finished the work while in the case of internal check, the work is so distributed that the work of one clerk is automatically and independently checked by another simultaneously.
(4) In internal audit, errors and fraud which have already been committed can be discovered but the system of internal check is so devised that the possibilities of errors and fraud or irregularities are reduced to the minimum.
(5) The work involved in internal audit is just like that of a watchman. The internal auditor has to see how far the work of the business is being done correctly and according to rules described for the purpose. A system of internal check is a process in itself under which work goes on uninterruptedly and checking, too, is more or less automatic.
(6) Both internal audit and internal check are two important organs of a system of internal control and as such, both are complementary and go together.
Virtually, the management adopts the system of internal audit to ensure that the existing system of internal control is adequate and effective; that the financial records reveal the results of business operations and transactions correctly and all the units of the organization follow the policies and practices framed and laid down by the management. Thus, the system of internal check is a device for doing work while internal audit is expected to check it in the light of policies and procedures laid down by the management.
Fundamental Principles of Internal Check
The following are some important rules of making the system of internal check efficient and successful.
(1) The work of the business should be allocated amongst various clerks that their duties, rights and responsibilities may be clearly and judiciously divided and there may not be left any room for interference,
(2) The distribution of work should be so done that no single person is allowed to do a fob solely by himself from the beginning to the end.
(3) One person should be entrusted with the similar nature of work. It is necessary for efficiency and specialization.
(4) It is also necessary that no clerk should be engaged on particular job for long. Change in duties would become essential but it will absolutely depend upon the circumstances prevailing before a business. Nevertheless, such a change in duties should be made without making it known to those concerned.
(5) An efficient system of internal check must provide for an automatic checking of the work of an assistant by another.
(6) The division of work should not be expensive.
(7) No clerk of the business should be relied upon too much.
(8) For making the system of internal check efficient and successful, use of sell-balancing system should be invariably made.
(9) Labour-saving devices, as cash register, calculating machines, time recording clocks, etc., should be made use of.
(10) There should be a proper system of filing vouchers, correspondence, etc., in the business.
(b) Those Relating to Specific Jobs
(11) A responsible official should be made responsible for receiving letters, etc. All Important letters, registered envelopes and money orders should be entered in a proper register and then passed on to the clerks concerned.
(12) All the cash received should be sent daily to the bank.
(13) Persons dealing with cash, securities, cheques, etc., should be compelled to take annual holidays in unbroken periods.
(14) Purchase, receipt and issue of goods should always be done under strict supervision and control. No one should be permitted to take away any goods without proper sanction.
(15) Jobs relating to bad debts, allowances, returns etc., should be performed under strict control.
(16) It should be seen that some responsible person is assigned the task of dealing and corresponding with the debtors and creditors of the business.
(17) Important work like payment of wages, valuation of stock, sales, etc., should be done under strict supervision and control.
Advantages of Internal Check
(a) For the Business Itself
(1) Internal check entails a proper and rational distribution of work between the members of the staff of a business and hence, their duties can be determined precisely. (BCom 3rd Year Internal Control and Internal Check in Auditing Notes Study Material)
(2) It helps in the detection and discovery of errors and fraud.
(3) Besides, the possibilities of the commission of errors and fraud can be minimized.
(4) A good system of internal check increases the efficiency of work in a business as the clerks do their jobs carefully and cautiously.
(5) The efficient work resulting from efficient operation of internal check enables the staff to prepare the final accounts with ease and quickness.
(6) Since the whole system of internal check is based on the principles of division of labour and specialization, a moral check is exercised on the clerks of business and this leads towards more efficient and economic operation.
(b) For the Auditor
(7) If there is a good and efficient system of internal check, the auditor may rely upon it and may not feel the necessity of making detailed checking of the accounts. (BCom 3rd Year Internal Control and Internal Check in Auditing Notes Study Material)
(8) The auditor may apply a few tests here and there very conveniently. He has to look to the shortcomings and defects inherent in the system and then take a decision as to what extent he can rely on it and apply tests.
(c) For the Owner
(9) If there is a good internal check system, the owner may rely upon the genuineness and accuracy of the accounts.
(10) If his business is run with an efficient system of internal check, it becomes a more efficient, economical and profit-yielding venture. The cost of production thus reduced can also be to his advantage.
Disadvantages of Internal Check
(1) The clerks of a business become quick and not so serious as they ought to have been.
(2) The possibility of some of the responsible and high officials being careless increases as they feel a sort of over-confidence that the work is automatically going on efficiently. (BCom 3rd Year Internal Control and Internal Check in Auditing Notes Study Material)
(3) Internal check may be quite expensive, especially for small business-houses.
(4) If the whole system is not properly organized, it may create chaos and disorder in the working of a business.
(5) The work of the auditor cannot be free from irregularities if the system is itself defective.
To provide a safeguard against its disadvantages, it is essential that the system o Internal check should be adopted very cautiously and carefully. Nobody can gainsay in fact that the system is of vital significance for the efficient running of a business.
Internal Check and Auditor
To what extent should an auditor rely on the internal check system? This is a big question which will depend upon the magnitude of a business. It is true that an efficient system of internal check can make his work easy and convenient. He should first of all examine the system of internal check, keeping in view the following points:
(1) He should call for a brief statement from his client in regard to the system of internal check in operation.
(2) He should examine the system in the light of the size and nature of the business to ensure how far the system can be good and efficient.
(3) Lastly, he should see how far the system has possibilities of errors and fraud and whether the system is totally or partially unreliable.
Normally, these tests can help him in making a real assessment of the internal check system and if it is not defective, the auditor can depend upon it. What is needed is that he should examine the system carefully and work with prudence and caution. It is, of course, true that a good system can be of much help to him. (BCom 3rd Year Internal Control and Internal Check in Auditing Notes Study Material)
But if, on the contrary, the system is defective and has some weaknesses to arouse his suspicion, he should not presume that everything is alright. He should carry on a detailed checking of the books of accounts. The defects inherent in such a system can point to the directions in which chances of errors and fraud exist. (BCom 3rd Year Internal Control and Internal Check in Auditing Notes Study Material)
If the auditor does not care for these shortcomings and fail to detect an irregularity, he will be held responsible. But, if the client so likes, he may seek advice from the auditor to make improvements in the system. If the client does not follow the advice and defects are found in the accounting system, the auditor should mention this fact in his report.
Can a good internal check system reduce the liability of an auditor? The answer is, quite obvious, “No, never.” The existence of such an efficient system of internal check can reduce to a great extent the work of the auditor but does not in the least reduce his liability. But if the system is full of defects, his work becomes difficult. Whatever the situation, the entire responsibility is his alone.
He cannot be relieved of his liability on the ground that since the system of internal check was good, he did not perform a particular function. This is no argument. Thus, a good and efficient system of internal check is of much help to him but is in no way a device to relieve him of his liabilities and responsibilities. To what extent should he depend upon the system will depend upon the circumstances of each particular case and his own skill, experience and training. (BCom 3rd Year Internal Control and Internal Check in Auditing Notes Study Material)