Auditing

Module No. 2: Risk Assessment and Internal

Control (12 hours)
• Introduction- Audit risk (Meaning 2 marks)
• Recognising the Inherent Risk of Errors and Frauds,
misstatements in financial Statements- Fraud risk factors with
examples. (5 marks)
• Assessment of risk – Auditors responsibility to consider fraud
and errors in audit of financial statements (5 marks)
• Internal Control- Meaning, Features, Divisions (2and 5 marks)
• Internal check- Meaning, objectives and fundamental Principles.
(15 marks)
• Internal check with regards to wage payment, cash sales, and
cash purchases. (15 marks)
 Risk Assessment and Internal Control

Introduction
From innocent but costly mistakes to deliberate fraud, all
organizations are subject to risks that can put at risk to financial
reporting or lead to the loss of corporate assets That’s why it is
imperative to establish a robust system of internal control to reduce
or prevent such threats and strengthen financial reporting.
The identification and assessment of risks of material are at the core
of every audit, particularly obtaining an understanding of the entity’s
system of internal control and assessing control risk. Performing an
appropriate risk assessment, enables the auditor to design and
perform responsive procedures. This is the source of news, resources
and learning relative to the audit.

Meaning and Definition of Audit Risk

Audit risk may be defined as “the risk that the auditor expresses an
inappropriate audit opinion when the financial statements are
materially misstated. Audit risk is a function of material misstatement
and detection risk”

Recognizing Inherent Risk of Errors and Frauds Misstatement

in financial statements
1. Error
The term “error” in audit context refers to “unintentional mistakes in
the preparation or presentation of financial information.” “Auditor’s
responsibility to consider fraud and error in an Audit of financial

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statement” states that errors are unintentional misstatement or
omission of disclosure of amounts in the financial statements.

Types of Errors
The errors, in general, may be of following types:
1. Clerical Errors: Errors in recording, posting, totaling and
balancing are called clerical errors. Clerical errors can further be
subdivided as Errors of omission, and Error of commission.)

(a) Errors of Omission: Errors of omission are the errors

where a transaction is omitted wholly or partially in the
books of account.
(b) Error of commission: Error of Commission include
wrong posting of amounts, posting on the wrong side,
posting in wrong account, error in totalling and balancing,
errors in carry forward, totals, trial balance and so on.
2. Errors of Principle: Error of principle occurs when generally
accepted accounting principles are not observed while recording
any transaction in the books of account.
3. Compensating Errors or Off-setting Errors: Compensating error
or off-setting error is counter-balanced by another error or
errors. In other words, compensating errors are those errors that
result in compensating the effect of other errors.
4. Errors of duplication: Errors of duplication occur when the same
transaction is recorded twice in the books of original entry, and
hence, are also recorded twice in the ledger accounts.

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Fraud
Fraud means “false representation or entries made intentionally or
without having belief in its truth with a view to defraud somebody.”

Types of Fraud
1. Embezzlement of Cash: Manipulation of money is found more in
big business houses in comparison to small proprietary
businesses because of direct control that is missing in big
entities. A system of internal checks becomes essential in large
business firms. Thus, an auditor is required to deal with cash
transactions more carefully.
The auditor should check the debit side of the cash book with
the rough cash book, salesmen’s reports, counterfoils of receipt
books, agent’s returns and other original records to discover
frauds mentioned in (a) and (b) above while frauds under (c) and
(d) can be discovered by reference to vouchers, wage sheets,
salary book, invoice and other such documents.
2. Misappropriation of Goods: Frauds are also committed in
respect of goods which are known as misappropriation of goods.
These types of frauds are most difficult to detect specially in
case of lesser bulky goods with higher prices. Proper methods of
keeping account with regard to purchase and sale, stocktaking,
periodical checking of stocks, comparing of percentages of gross
profits to sales of two periods is necessary to avoid
misappropriation of goods
3. Fraudulent Manipulation of Accounts: Fraudulent manipulation
of accounts is more difficult to detect as it is usually committed
by directors, managers or other responsible officials with an
object of:

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A. Showing more profits than they are to:
a) If they get commission on profits, they get more commission;
b) Maintaining confidence of shareholders by reflecting efficiency
due to increased profits;
c) If they hold shares, they may sell them at high price by declaring
higher dividends;
B. Showing lesser profits than actually they are in order to:
a) Purchase shares in the market at lower price;
b) To reduce or avoid payment of income tax;
c) To give a wrong impression about the success of the business to
the competitors.
C. Falsification of accounts may be resorted by:
a) Providing more or less depreciation in accordance with set
objective;
b) Showing fictitious sales or purchases or returns to increase or
decrease the figure of profits as per the case may be;
c) Utilization of secret reserves during the period in which concern
has earned lower profits without disclosing this fact to share
holders;

Such frauds are very difficult to detect as they are committed by the
people at the helm of the affairs who are presumed to be
trustworthy, honest and responsible and therefore, no suspicion falls
on them. He should carry out the routine checking and vouching most
carefully and make searching, tactful and intelligent inquiries.

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Internal Control
Internal control means “the mechanisms, rules, and procedures
implemented by a company to ensure the integrity of financial and
accounting information, promote accountability and prevent fraud.”
Internal Control system is one of the basic and essential factors for
efficient and effective management. It covers the whole management
system of an organization, both financial and non-financial. Internal
control system is helpful for the management and also the Auditor in
achieving goals and targets effectively

Features of Internal Control

1. Encourage adherence to prescribed policies: The system of
internal control is introduced to provide reasonable
assurance that the various plans, policies and procedures
laid down by the entity are being followed.
2. Avoid frauds and errors: The main objective of any control
system is to detect and prevent frauds and errors by
keeping an inherent check. It is one of the primary
objectives of internal check. As the work performed by
each individual is checked by another person, there is a
check on the work of dishonest person. Hence, the
possibility of errors and frauds are minimised to a greater
extent.
3. Promote operational efficiency: The internal controls
within an organization are meant to prevent unnecessary
duplication of efforts, protect against waste and discourage
any inefficient use of resources of the organization)
4. Safeguard assets and records: The other important
objective of internal control system is to safeguard the

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 assets and records from unauthorized access, use and
disposition.
5. Provide accurate and reliable data: The internal control
system ensures that all the transactions are recorded in the
correct way, in the appropriate account and in the
accounting period to which they relate.
6. Assist in timely preparation of Financial Information:
Information is of no use if it is not provided in time.
Internal control system facilitates timely preparation of
financial statements.
7. Early detection of Errors and Frauds: The main objective of
internal check is to detect and prevent the occurrence of
errors and frauds at an early stage, This is possible as the
work of each and every person is independently checked.
8. Division of work: Internal check provides for proper
division of work based upon each and every person’s skill,
ability, specialisation and effectiveness.

Division of Internal Control

1. Financial and other organizational plans: This can serve the form
appropriately classified by the flow chart. It must mention the
miscellaneous duties and obligations of both staff and the
management, expressing the powersof the authority dwells with
various members. This is essential as in the case of the absence
of the staff, or alternatively, the correct movement of work and
the Internal control system could be perverted by the improper
implementation of the techniques by employees either
innocently or purposely.

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 2. Competent personnel: Personnel are the most significant
components of any Internal control system. If the employees are
skilled and dynamic in their accredited work, an Internal control
system can be managed efficiently even if few other
components of it are absent
3. Division of work: This attributes to the process of division of
work accurately among the personnel of the enterprise. Every
single work of the enterprise must be divided into various stages
and must be assigned to the personnel according to their quality
and skills.
4. Authorization: Under the Internal control system, all the actions
must be approved by an appropriate authority. The individual
entity or association which can either holds specialized or
general authority for business dealing must hold a position
adequate with nature. The importance of business dealing and
the policy for the aforementioned authority must be entrenched
by the top management.
5. Dissolution of operational responsibility from record keeping: If
every department of an enterprise is being appointed to arrange
its shape results for manifesting better performance. Thus, to
ensure trustworthy records and information, record-keeping
work is detached from the operational responsibility of the
affected department.

Internal Check
Meaning and Definitions of Internal Check
Internal Check refers to “the checks on day to day transactions which
operate continuously as part of the routine system, where the work of
one person is proved independently or in complementary to the work

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of another, the object is the prevention or early detection of errors or
frauds.”
In other words, “Internal Check is an arrangement of accounting
routine that errors and frauds are automatically prevented or
discovered by the very operation of book- keeping itself.”

Objectives of Internal Check

The objectives of internal check are as follows:
1. Detection of Errors and Frauds: The main objective of internal
check is to dected and prevent the occurrence of errors and
frauds at an early stage.
2. Minimization of Errors and Frauds: It is one of the primary
objectives of internal check. As the work performed by each
individual is checked by another person. It is a process of check
on the work of dishonest person. Hence, the and frauds are
minimised to a greater extent by this process. Possibility of
errors
3. Division of Work: Internal check provides for proper division of
work based-on each and every person’s skill, ability,
specialisation and effectiveness.
4. Fixation of Responsibility: The total work is divided into smaller
units and assigned to different persons. Each and every person
knows what is expected from him/her and he/she will be held
responsible for any errors or fraud which takes place in it.
Internal check provides for clear determination of responsibility.
5. Reliability of Records: The system ensures that the books of
accounts and other records maintained provides reliable source
of information.
6. Moral Check: The purpose of the internal check is to develop
high moral values. The work of one employee is supervised and

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 checked by another employee. All employees feel the sense of
responsibility; they complete their work on daily basis. Thus the
efficiency of workers increases.
7. Recording Facts: The purpose of the internal check is to record
facts and figures in the books of accounts.

Principles of Internal Check

Let us now understand the principles of Internal Check:
1. Sufficient Staff: The principle of internal check is ensuring the
sufficient star Employees can be appointed according to
workload. The management can determine the amount of work
which is distributed among the departments. The persons are
hired to perform their duties; the overloading can create trouble
for management.
2. Division of Work: Division of work is the second principle of
internal check. The management can determine the total
amount of work. The whole work is divided among departments.
3. Coordination: Coordination is another principle of internal
check. All departmental managers are bound to coordinate with
each other in order to achieve the objectives of the organization.
4. Rotation of Duties: The workers get bored by doing the same
work from year to year. There is a need for rotation of duties. It
is in the interest of the concern as well as the employee. The
efficiency improves due to change in duties.
5. Recreation Leave: The employee can enjoy the recreation leave.
It is necessary for the mental health of the employee. He cannot
commit frauds as the new employee in his place can disclose the
matter to the management.

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 6. Automatic Machines: The principle of internal check is that
machines must be used to do accounting work if permissible.
The machines can do a lot of work without delay. The chances of
frauds and errors are reduced to a minimum. The working of
machines improves the efficiency of the accounting staff.
7. Checking: The principle of an internal check to check the work of
other employees. Many persons perform the work. The officer
can put his Signature to verify the work done by his subordinate.
In this way one Work passes many hands, the chances of errors
and frauds are minimized due to checking and counter-checking.
8. Simple: The principle of internal check is simple working. The
employee can understand the working of the internal check
system. A person can work under the supervision of other
employees.
9. Documents Classification: The classification of documents is one
of the principles of internal check. The business documents are
prepared, collected, recorded and placed in proper files. The
index is prepared to compile data. The filing system is useful to
place letters. In case of need, the documents can be traced
quickly.
10. Dependent Work: Dependent work is the last principle of
internal check. The work of one employee is dependent upon
the others. One work passes through the hand of two or three
persons till it is completed. The senior person checks the work of
junior person.

Internal Check related to different aspects

Let’s focus on different aspects of Internal Check related to following
aspects:

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 1. Wage Payments,
2. Cash Sales, and
3. Cash Purchases.

1. Wage Payments: In case of a large manufacturing, where the

workers are in large number, a satisfactory system of internal
check should be introduced to avoid more payment of wages
due to incorrect or incomplete record of time wage or piece
wage inclusion of fictitious names of dummy or ghost workers in
the wage sheets.
The internal check system of wage payment is divided in three parts:
a) Recording of time,
b) Preparation of wage sheet, and
c) Payment of wages.
Let us now discuss the internal check system of wage payment which
are divided in three parts:
a) Recording of Time: Generally, each worker is given a time
card on which details about the person, rates of wages,
date of increment, if any and other related instructions are
given. Daily time spent by the person on the job is
recorded on this card.

Devices for Recording Time

1. Time Recording Clock: A time office at the entrance of the
factory records and the time of entry and exit of each worker
with the help of a recording clock. The worker puts his card in
the slot of the clock and the date and time are recorded on this

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 card. In this way correct and clear record of time spent in the
factory is put on the card.
2. Token System: Under this system, a token duly numbered is
issued to each worker who keeps it hanging on board meant for
the purpose. When he enters the gate, time keeper records his
attendance in the attendance register.
3. Attendance Card: In some business organizations, attendance
cards are Issued to workers. He drops it in the card box meant
for that purpose, and collects in the evening. The time officer /
gate keeper records his attendance on the card.
4. Piece work record: When wages are paid on the basis of work
done, a job card is issued to each worker and the amount of
work done by a worker is recorded on this card under the
signatures of workman and foreman.
5. Over time Record: When a worker is given overtime work, he is
issued an overtime slip on which details about his name, duty
time etc. are given by the work-manager duly certified by the
foreman of the department.

b) Preparation of wage sheet: At the end of the work, job

cards or attendance register, overtime slips etc. are
submitted to the wage department which prepares the
wage sheet on the basis of these records separately for
time wages and for piece wages. Wage sheets of different
departments are prepared separately. After preparing the
wage sheet, they should be checked by another person.
c) Payment of Wages: On the wage day, wage sheets are
passed over to the cashier who withdraws the necessary
amount form the bank for payment of wages. The cashier
should take the following precautions. No person
associated with the preparation of wage sheet should take

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 part in payment of wages. As far as possible, pay-pocket
should be prepared for each worker. Payment of wages
should be made only to the worker concerned. Foreman of
the department should be present at the time of payment
of wages to avoid impersonation of workers who are
absent on that day. Workers who are absent may collect
their wages next day or any other person may collect any
body’s pay pocket on the basis of a letter of authority duly
authorized and attested by the worker.
2. Cash Sales: Internal check as regards Cash Sales in a big business
organization, wherein large number of daily cash transactions takes
place. There are many chances of frauds and irregularities happening
if there is no good system of internal check. There may be three types
of cash sales:
a) Cash sales at counter,
b) Sales by travelling agents, and
c) Sales by Post.
a) Cash sales at Counter: The internal check system should consist
of the following elements:
1. Every salesman who is authorized to do cash sales should be
specifically demarcated.
2. Four copies of cash receipt should be generated out of which
three will be handed over to the customer out of which
customer will give one copy to cashier at the time of payment
and one copy to gatekeeper at the time of delivery of goods and
exit from gate and one copy will be retained by the customer.
3. Three sales summaries will be prepared, one by the Salesman,
second by the Cashier and the third by the Gatekeeper to tally
the cash sales on daily basis.

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 4. All Cash Sales should be deposited into bank on daily basis
without any failure and without deducting any expenditure or
commission out of it.
5. Cash received (as per cash recording machine), cash sales and
amount deposited into bank should be same.
6. Every salesman in charge of making sales should be allotted a
number or a specific name.
7. Cash sale invoices or cash memos should be pre numbered and
be of different colours for different departments,
8. The salesman at each counter should prepare pre numbered
cash memos in triplicate,
9. Two copies are handed over to the customer who carries them
to the cashier. Cashier receives the cash and stamps them cash
paid. He returns one copy to the customer and the other copy is
retained by the cashier. The goods sold are then handed over to
the customer either by the cashier or by the salesman.
[Link] goods are handed over to the customer by the gate keeper,
four copies are required to be made by salesman, In such cases,
one copy is retained by the gate keeper.

b) Cash Sales by travelling agents: In some business houses,

travelling agents are appointed to make sales. In such a case,
internal check system may be as under

1. The agents authorized to sell goods for cash should issue a

temporary receipt for the cash received and the customer should
be instructed to get the receipt from the head office.
2. The head office/branch office shall issue and mail a confirmed
receipt to the customer within a stipulated period. If the

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 customer does not receive the receipt within that period, he
should enquire for the same from the head office.
3. The agent should be instructed to remit the cash collected daily
or periodically or deposit it into the bank account of as per
instructions of the head office without any deduction for salary
or commission payable to him.
4. The head office should send the statement of accounts regularly
to each individual customer to keep him informed about the
amount due to him.
5. The agent should also send account sales giving full details of
sales made. Cash collected and send and expenses incurred to
the head office.
6. The agent should be transferred from one area to another
without any prior information to him. This will help avoiding
trends or their collusion with customers and to increase their
efficiency.
7. Pre-numbered rough cash receipt book should be issued to every
salesman for the collection of debt or advance from customers.

Cash sales by Post: Postal cash sales should be recorded in separate

register. A separate register should be maintained to record the cash
received against postal sale. Cash received and goods retained on this
account should also be entered in this register. Cash received through
postal sale should be deposited into bank separately. Regular and
careful checking of the sale and payment register should be done by
an officer of the company. A responsible officer should be deputed to
check carefully the Value Payable at Post (VPP) register and the goods
for which cash has not been received should be especially audited. In
this connection cash received should be checked carefully from cash
book. Orders received should be filed date wise and in serial order.

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[Link] Purchases: Internal Check with regard to Cash Purchases is
discussed in the following paragraphs in detailed as under:
a) Requisition: The procedure for issuing purchase requisitions
should be clearly specified. The head of the department, who is
in need of goods, should fill in a requisition slip duly signed and
then should send it to the purchases department.
b) Enquiry: Purchase department makes an enquiry about the
terms and conditions of purchases from different suppliers. For
this purpose tender are generally invited. But, who shall open
and accept the tenders, should be clearly specified.
c) Purchase Order: The Purchase Department places orders which
should be recorded in the Purchase Order book. Four copies of
purchase order should be prepared. One copy will be sent to the
vendor, second to the store department, third copy to the
Accounts department and fourth one will be retained by the
purchase department itself.
d) Receipt of Goods: On receipt of goods, the purchase department
should be properly inspecting them, and there after an entry in
the goods inward (Receipt) book, the same should be sent to the
stores. Concerned department should be informed about the
receipt of the goods.
e) Making the Payments: The Purchase Department should
thoroughly check the invoices and send the same to accounting
department for payment. The accounting department should
compare the invoice with the purchase order and incoming
Inspection Report and also verify the calculation. The Accounts
Department should enter the invoice in the Purchase Book. Only
responsible official should draw cheque for the payment of
invoice. At the time of signing, a signing authority must verify
that correct payment is made.

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A good system of internal check with regard to purchase will prevent
the following types of irregularities, errors and frauds.
[Link] Payment: Fictitious Purchase may be recorded in the
purchase book and the payments withdrawn may be
misappropriated.
[Link] Payment: Some invoices may be recorded twice and double
payment made may be misappropriated.
[Link] inflation in profits: Goods purchased may not be entered in
the period so as to inflate profits.
[Link] reduction in profits: Goods not received in one period may
be entered as purchases so as to show profits less than the actual.

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