Question

Jessica Mahan is the new owner of Penny Parking. She has heard about internal control but is not clear about its importance for her business.

Explain to Jessica the four purposes of internal control and give her one application of each purpose for Penny Parking.

Answer 1

Internal controls are the merchanisms, rules and procedures implemented by a company to ensure the integrity of financials and accounting information, promote accountability and prevent fraud.

Importance of internal controls:

Internal conrols reduces the risk of loss of assets and helps to ensure that plan information is correct and accurate, financial statements are reliable and the plan operations are conducted in accordance with provisions of applicable laws and regulations.

Purpose of internal controls:

1) Internal controls helps to address financial statement assertions. It means its purpose is to safeguard the organisation asstes and thus address financial statement assertions.

Example : (i) Performing a physical count of inventory internally. Count inventory and track them in the accounting system to ensure the existence.

(ii) Count cash receipts in retail sales before recording them to verify accuracy

2) Internal control helps to prevent and detect fraud. This can be done by segregation of duties (SOD). The principle of SOPD is to share responsibilities in a key process such that no one individual should perform two of the three functions : Custody, recording and authorization. when three responsibilities are segregated, fraud can be prevented or detected. Another way by limiting access to only authorised personnel.

Ex: (i) When an accountant receives cash and another accountant records the cash. At the same time, the accounting manager reviews the cash records and reconciliation to detect any errors or fraud.

(ii) Preventing unauthorized personnel from getting access to a warehouse and stealing inventory for resale.

3) Internal controls helps to prevent misstatement of financial statements.

Ex: Prepare reconciliation that ensure the account balances on the balancesheet are correct to prevent misstatement of financial statements. Reconciliation also helps management to detect errors and understand company operations.

4) Internal control helps to establish best practices. If there is no document evidence of internal controls, you cannot prove internal controls exist.

Ex: Documentation for internal controls are flow charts or narratives. It helps employees get a better understanding of the company process and practices which helps to establish the company practices.