Question

You have ascertained and recorded the system of internal control and decided that you wish to place reliance on the controls in many areas. The results of your compliance tests on purchases and stocks reveal that:
i) Out of 100 purchase invoices selected for inspection, 2 could not be found and 2 were not initialed as checked and approved for payment.
ii) Out of 120 stock cards inspected, 4 contained an instance where the delivered quantity had been altered by a significant amount.
iii) One supplier is regularly paid before supplies are delivered on the basis of pro forma invoices which are processed through the creditors’ ledger system on receipt so as to initiate the necessary payments. No other exceptions were noted.

1) Outline what further procedures should be carried out in order to be able to reach a conclusion on whether the company’s system of internal controls can be relied upon, indicating what factors you would consider in reaching your conclusion.

2) Having reviewed your files you find that previous management letters have outlined the problem that one supplier is being paid based on pro forma invoices prior to delivery. No action has been taken by management to rectify this problem. What should be done about this?

Answer 1

The internal control structure of a company consists of the policies and procedures established to provide reasonable assurance that specific entity objectives will be achieved. In small business organizations, generally, the owner-manager controls the total activities of his business by his personal supervision and direct participation.

For example;

The owner generally purchases required business materials and other properties.

He himself gives the appointment of employees, completes the contract with them through discussion and also keeps, constant watch over their activities.

He himself signs cheques for payments in different heads.

Since the signs all the cheques, he can easily have an idea of what commodities, assets, and services he is signing for.

But with the expansion of business, the appointment of additional employees and officers is needed and the scope of business also widens.

Under such conditions, it becomes almost impossible on the part of the manager to perform all the activities of the business alone for which he is to delegate authority and so his overall control tends to decrease.

In such circumstances the introduction of internal control becomes essential.

The internal control system differs from one business organization to another depending on the nature and size of the business.

To achieve the objective of a business proper execution of business activities in the light of prevailing laws and socio-economic conditions of the country is called an internal control system or structure.

The internal control system is introduced to avoid errors and frauds and for systematic control of business activities.

American Institute of Certified Public Accountants (AlCPA) says; the plan of organization and all of the coordinate methods and measures adopted within a business safeguard its assets, check the accuracy and reliability of its accounting data, promote operational efficiency and encourage adherence to preserved managerial policies.

Three elements of the internal control system are:

1. Environment control: The attitude, alertness, and work-zeal of directors, managers and shareholders are reflected through environmental control.
2. Accounting system: Accounting system means some procedures and recordings with which identification of business transactions, classification, summarization, statement preparation and analysis for timely presentation of correct information are performed.
3. Control procedure: The additional policies and procedures adopted by the business authority for ensuring the achievement of the specific goal of a business organization are the controlling procedures.

These control procedures are:

• Proper delegation of power,
• Segregation of responsibility,
• Preparation and use of documents,
• Adoption of adequate security measures to protect the properties, and
• Independent control over the execution of activities.

An internal control system, not only prevent fraud forgery but also fulfills other objects:

1. The business organization implements its policies complying with the prevailing laws of the country.
2. Employees and officers discharge their assigned responsibilities to increase efficiency in the execution of work.
3. Financial statements provide correct and reliable information maintaining proper accounts.

In light of the above discussion, it can be briefly stated that the overall policies and plans adopted by the management for the proper execution of business activities are called the internal control system.

5 Components of Internal Control System

1. Controlling the environment

   The control environment is the basis of other elements of all other components of the internal control system. Moral values, managerial skills, the honesty of employees and managerial direction, etc. are included in the controlling environment.

2. Risk assessment

   After setting up the objective of business, external and internal risks are to be assessed. The management determines risk controlling means after examining the risks related to every objective.

3. Control activities

   The management establishes a controlling activities system to prevent risk associated with every objective. These controlling activities include all those measures that are to be followed by the employees.

4. Information and communication

   Relevant information for taking decision are to be collected and reported in proper time. The events that yield data may originate from internal or external sources.

   Communication is very important for achieving management goals. The employees are to realize what is expected of them and how their responsibilities are related to the activities of others. Communication of the owners with outside parties’ like’s suppliers is also very important.

5. Monitoring

   When the internal control system is in practice, the organization monitors its effectiveness so that necessary changes can be brought if any serious problem arises.

Responsibility for Internal Control System

It is the general responsibility of all employees, officers, management of a company to follow the internal control system.

The under-mentioned three parties have definite roles to make internal control system effective:

1. Management

   Establishment and maintenance of an effective internal control structure mainly depends on the management. Through leadership and example or meeting, the management demonstrates ethical behavior and integrity of character within the business.

2. Board of directors

   The board of directors possessing a sound working knowledge gives directives to the management so that dishonest managers cannot ignore some control procedures. The board of directors stops this sort of unfair activity. Sometimes the efficient board of directors having access to the internal audit system can discover such fraud and forgery.

3. Auditors

   The auditors evaluate the effectiveness of the internal control structure of a business organization and determine whether the business policies and activities are followed properly. The communication network helps an effective internal control structure in execution. And all officers and employees are part of this communication network.

3 Objectives of Internal Control System

Internal controls system includes a set of rules, policies, and procedures an organization implements to provide direction, increase efficiency and strengthen adherence to policies.

3 objectives of internal control are;

1. financial reports are reliable,
2. operations are effective and efficient, and
3. activities comply with applicable laws and regulations.

Characteristics of a Proper Internal Control System

An effective internal control system includes organizational planning of a business and adopts all work-system and process to fulfill the following targets:

1. Safeguarding business assets from stealing and wastage.
2. Ensuring compliance with business policies and the law of the land.
3. Evaluating functions of each employee and officer to increase efficiency in operation.
4. Ensuring true and reliable operating data and financial statements.

It is to be kept in mind, a business organization, be it’s small or large, can enjoy the benefits of adopting an internal control system.

Prevention of stealing-plundering and wastage of assets is a part of the internal control system.

The accuracy of accounting records

A business organization should maintain a complete and correct accounting record.

For ensuring proper maintenance of accounts efficient and honest personnel are to be appointed and trained.

The performance of the employees is evaluated at intervals. By the supervisors to ensure that the policies of the business are followed by the employees.

An inaccurate or incomplete accounting record prompts the dishonest employees to steal because they can easily subside the act of stealing.

Transactions accounted for are the documentary evidence of business.

This documentary evidence is an integral part of internal control systems.

These documents are to be arranged serially for convenient control. Since these primary documents are the documentary evidence of transactions of a business, the validity of these documents is to be checked from time to time.

For example,

The documents used for recording transactions of accounts are examined for the re-audit purpose of the merchandise inventory of a business organization.

While maintaining accounts of transactions the accountant is. to preserve the following four documents:

1. Purchase requisition: Written order placed by the officers of the department concerned to the purchasing department for purchasing a certain quantity of goods is called purchase requisition.
2. Purchase order: Before purchase, the buyer sends a written order to the seller requesting him to send particular goods. This written order is called a purchase order.
3. Invoice/Chalan: The seller sends an invoice with the sold goods to the buyer wherein the descriptions, quantity, rates of the goods are mentioned.
4. Receiving report: It is a purchase document prepared by an officer of the purchasing department. It is treated as documentary evidence of the goods received.

The flow of documentary evidence of business transactions and commodities is shown below by a diagram:

Steps:

1. Requisition department sends a purchase requisition to the purchasing department.
2. The purchasing department sends a purchase order to the supplier, with copies going to the receiving department and accounting department.
3. The supplier sends goods to the receiving department, where goods received are checked against the purchase order and send an invoice to the accounting department.
4. The receiving department sends goods to the requesting department and sends receiving a report to the accounting department.
5. Accounting department checks to receive reports against the purchase order and invoice and sends a cheque for payment of invoice to the supplier.

The price of purchased goods is paid on the basis of these four documents and these are compared with accounting records.

A business concern fails to make payment of a legitimate invoice without these documents or it might have to make payment of the fictitious invoice or more than one invoice.

A business concern effectively completes its internal control system comparing sources and documents with accounting records of those transactions.

It is unfortunate that a business concern adopting its internal control system cannot avoid theft altogether.

A dishonest employee always tries to misappropriate no matter whatever effective control systems exist as in a business concern.

Therefore, a business concern has to make an arrangement of casualty insurance on its assets. Under this system loss of non-cash assets is reimbursed.

Besides,

A business concern may arrange fidelity bonds between employees handling cash and other negotiable instruments. Under this system, a business concern will get reimbursement of money lost or theft.

Under these two systems i.e., casualty insurance on assets and fidelity bonds on employees, a business concern can recover at least a portion of any loss caused due to stealing, misappropriation, etc.