Principles and Practice of Auditing

Unit 2: Risk Assessment and Internal Control

MEANING OF INTERNAL CONTROL

Internal Controls are systemic and procedural steps adopted by an organization to mitigate
risks, primarily in the areas of financial accounting and reporting, operational processing and
compliance with laws for the smooth functioning of the whole system.

In short, Internal Control refers to the various method and procedures adopted by the
management for the smooth functioning of the whole system.

DEFINITION OF INTERNAL CONTROL

According to [Link] "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”

Internal control, as defined by Accounting and Auditing, A process for assuring of an

organization's objectives in operational effectiveness and efficiency, reliable financial
reporting, and compliance with laws, regulations and policies.

OBJECTIVE OF INTERNAL CONTROL/ADVANTAGES

1. To safeguard the assets of the business from unauthorized access, frauds and wastage.
2. To conduct the business orderly and systematically.
3. To prevent and deduct frauds and errors.
4. To ensure timely preparation of financial information.
5. To ensure high degree of accuracy and reliability of accounting data and promote
operational efficiency.
6. To measure how far the policies of management are implemented.
7. To evaluate the efficiency of performance in the various activities of the business.
8. To see that access to and use of assets are made only with proper authorization.
9. To ensure that there is periodical verification and comparison of assets
10. To ensure that transactions are recorded in the proper books of accounts regularly,
correctly and systematically, according to policies and procedures.
Principles and Practice of Auditing

DISADVANTAGES OF INTERNAL CONTROL

1. Expensive: Expensive for small companies as internal control requires more cost for
control procedures.
2. Chances of human error: The possibility of human error due to carelessness, mistakes
of judgment or the misunderstanding of instructions may make the system ineffective.
3. Rigidity: There is the possibility that the system may become inadequate due to
changes in the conditions, and compliance with procedures may deteriorate.
4. Responsibility: It may happen that a person responsible for exercising control abuses
his responsibility
5. Collusion: There may be the possibility of circumvention of controls through collusion
with parties outside the entity or with employees of the entity.

METHODS FOR EVALUATING INTERNAL CONTROL

1. Internal Check
2. Internal Audit

INTERNAL CHECK

Internal check is an arrangement of the duties of the staff members of the accounting functions
in such a way that the work performed by a person is automatically checked by another so that
errors and frauds are prevented.

• Internal check is regarded as checks on day-to-day transaction.

DEFINITION OF INTERNAL CHECK

According to Spicer and Pegler

"A system of internal check is an arrangement of staff duties whereby no one person is allowed
to carry through and to record every aspect of a transaction so that, without collusion between
two or more persons, fraud is prevented and at the same time the possibilities of errors are
reduced to a minimum."
Principles and Practice of Auditing

OBJECTIVES OF INTERNAL CHECK

1. Assigning responsibility: To allocate the duties and responsibilities of every employee

in such a manner that they may be identified and held responsible for a particular error
or fraud.
2. Minimizing error or fraud: To minimize the possibility of any error or fraud done by
any staff member.
3. Detecting errors or frauds: To detect errors or frauds easily due to independent
checking of work done by one employee by another employee.
4. Reducing clerical mistakes: To minimize the possibility of omission of any
transaction from being recorded in the books of accounts.
5. Enhancing work efficiency: To enhance the efficiency of the staff, as the management
of duties, based on the principle of division of labour.
6. Obtaining confirmation: To obtain confirmation of facts and entries, physical and
financial, by the presentation and necessary maintenance of records.
7. Reducing burden of work: To reduce the burden of the work of independent auditor
by introducing the internal check system in a scientific way.
8. Exercising moral pressure: To exercise moral pressure on the employees by
introducing continuous review process of the total system.
9. Ensuring reliability: To facilitate business control by ensuring the reliability of
accounting records and books.
10. Obtaining supervision advantages: To obtain the advantages of supervising the
various asset inflow and outflow of cash and goods of the business.

FUNDAMENTAL PRINCIPLES OF INTERNAL CHECK

1. Sufficient staff: The principle of internal check is sufficient staff. The employees can
be appointed according to the 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 a principle of internal check. The management
can determine the total amount of work. The whole work is divided among the
departments. The heads of such departments are responsible for completion of work
according to timetable.
Principles and Practice of Auditing

3. Rotation of duties: Rotation of duties is a principle of internal check. The workers feel
bored by doing the same work from year to year. There is a need of rotation of duties.
It is in the interest of concern as well as employees. The efficiency is improved due to
changes is duties.
4. Coordination: Coordination is a principle of internal check. All departmental
managers are bound to coordinate with others in order to achieve organization
objectives. When there is fault in one department, the work of another department
suffers. The objectives cannot be achieved. Internal check determines the degree of
coordination among the managers.
5. Dependent work: Dependent work is a principle of internal check. The work of one
employee is dependent upon others. One work passes in the hands of two or three
persons till it is complete.
6. Responsibility: Responsibility of each individual must be properly defined and fixed.
The work of the business should be allocated amongst various clerks in such a manner
that their duties and responsibilities are clearly and judiciously divided
7. Periodical review: The financial and administrative power should be distributed very
judiciously among different officers and in such manner that those which are actually
exercised should be reviewed periodically.
8. Supervision: A strict supervision should be exercised to ensure that the prescribed
internal checks and procedures are fully operative.
9. Use of Automatic Machines: According to the principles, machines must be used to
do accounting work if permissible. The machines can do a lot of work without delay.
The changes of fraud and error are reduced to a minimum. The working of machines
improves efficiency of accounting staff
10. Classification of documents: The classification of documents is the principle of
internal check. The business documents are prepared, collected, recorded and placed in
proper files. The index is prepared to compile the data.

ADVANTAGES OF INTERNAL CHECK

A. From business point of view

• Proper allocation of work: Rational allocation of work among the different
staff members of the organization brings precision in work.

4
Principles and Practice of Auditing

• Control device: The distribution of work under this system is such that it acts
as a control device against unscrupulous employees. The chances of fraudulent
manipulation are thus minimised due to the existence of this check.
• Speedy work: As the individual staff is engaged in the same type of jobs for a
considerable period of time, it results in the efficient performance of the
activities and high speed of work.
• Increase in efficiency and skill: A good system of internal check increases the
efficiency of work among the staff due to its proper planning for assigning the
right job to the right person.
• Easy preparation of final accounts: Since no Individual worker is allowed to
handle a job completely and the work is divided among the employees in a
proper manner, the books of accounts can be kept up to date: as a result, the
final accounts can be prepared easily.
• Creation of moral check: Knowledge of subsequent checking of each
employee's work by another act as a great check to commission of errors and
frauds.
B. From the owner's point of view
• Reliability on accounts: If there is a good system of internal check, the owner
of the concern may rely upon the genuineness and accuracy of the accounts.
• Orientation of accounting: As the responsibility of each staff is clearly
defined and fixed, it develops a system of accounting which is known as
responsibility accounting.
• Economical operation: Although it seems that the introduction of well-
Integrated system of internal check is costly, in actual practice it is observed
that the staff patterns are so arranged that the existing staff be properly filled in
different operating areas involving no extra cost.
C. From the auditor's point of view
• Facilitation of audit work: Sound and efficient internal check system may
facilitate to a greater extent, the work of the auditor by relying on 'test check'.
• Attention to other important matters: As the auditor gains confidence on the
Internal check system, he can avoid the basic routine checking work to some
extent and can give attention to other important matters.

5
Principles and Practice of Auditing

LIMITATIONS OF INTERNAL CHECK

1. Expensive for small business: Internal check system requires a large number of
employees so it is quite expensive especially for small business.
2. Collusion among employees: In an internal check system there are possibilities of
collusion among employees. As a result, frauds may happen.
3. Dependence: Statutory auditors in almost all cases rely on the internal check system
Accordingly they apply test check and not a thorough check.
4. Risky for an auditor: If the auditor does not apply tests and procedures of his own and
if he relies on the output of the system his work cannot be free from irregularities.
5. Complexity: It may develop complexity among staff particularly with the top
management, which may damage the entire organization if anything goes wrong.

INTERNAL CHECK AS REGARDS TO:

I. Wage Payments
II. Cash Sales
III. Cash Purchases

WAGE PAYMENTS

Internal check as regards to Wage payments

A. Maintenance of wage records

B. Preparation of wage sheet

C. Payment of wages

A. Maintenance of wage record

a. Time records: Workers are paid their wages normally on the basis of time.
Thus, the time spent by each worker should be correctly recorded in the time
record-book and for this purpose the following methods are used.
• Time Recording Clock: At the time of entering into the factory the
worker puts his entry card in the slot of time recording clock, kept at
the entry of the gate. The clock records the date and the actual time of
Principles and Practice of Auditing

his entry in the factory. At the time of leaving the factory, he has to put
his card in the slot of the clock again for recording his actual time of
departure.
• Use of Tokens: Under this system, each worker is given a brass metal
token duly numbered. The workers at the time of entering into the
factory put their respective token in the appropriate place of the board.
On the basis of this token, the timekeeper records the attendance of the
worker in the attendance register
• Attendance Card: Here, the workers are given attendance cards. At the
time of entering into the factory, the workers put their attendance cards
in the box kept near the gate. The gatekeeper collects the same for the
purpose of recording time in the attendance register.
• Punching Machine (Biometrics): Use of Biometrics is a recent trend
in time records. Where it records in and out time.
• Use of Computers: Use of computers for recording of time of labours.
b. Piece work records: When the workers are paid on the basis of work
performed, they are provided with cards known as job cards' which contain
information relating to workers and their jobs, in the name of the worker, nature
of work allotted, the volume of work done and the wage or job rate. This card
is checked by the piece work reviewer along with the quality and quantity of
goods. This card helps in the preparation of wage sheet.
c. Overtime records: The question of payment for overtime to workers arises
only when it is sanctioned by the proper authority. The overtime slip is to be
given to each worker, who has been allowed to do the same Th slip contains
various information, viz. The name of the workers, detail about the job and the
rate at which wages are to be paid. The overtime record should be maintained
separately and it should be passed either foreman or by the works manager.
After that, the slip should be sent to the to do the same. This accounts
department for the preparation of wage sheet.
d. Pass-out records: Normally the workers are not allowed to leave the factory
during the hours of work, Sometimes the workers are compelled leave the
factory during the working period on some personal grounds. I that case, pass-
out slips are to be issued to the workers. Two copies of the slip are prepared.
Principles and Practice of Auditing

The original copy is to be handed over to the worker who at the time of leaving
the factory hand over the same to the gatekeeper and the other copy is to be
sent to the wage department for the preparation wage sheet

B. Preparation of wage Sheet: The preparation of wage sheet should be done by a

separate department. This work should be done by 5 clerks to minimize irregularities
• Two clerks should examine the time and price wage records, overtime records
and other statements
• The 3rd clerk is to prepare individual employee statement i.e. name of the
worker, code number allotted to him, his address, total time worked and the
rate of wages.
• The 4th clerk is to check the calculation and deduct the permissible amount i.e.
rent, provident fund, income tax, installment of loans and other permissible
deduction from the gross wages to arrive at the net amount to be paid to the
workers.
• The 5th clerk is to check the whole work thoroughly.

Contents in wage sheet

✓ Name of the worker

✓ Identification number allotted
✓ Total time worked in the production process
✓ Details of work done
✓ Applicable rate of wages
✓ Total amount of wages payable
✓ Bonus entitlement, if applicable
✓ Overtime wages, if any
✓ Deductions
✓ Net amount of wages payable

C. Payment of wages: The cashier should withdraw the necessary sum as shown in the
wage sheet under the column "net wages". After the amount has been withdrawn the
following procedure maybe adopted to avoid fraud.
Principles and Practice of Auditing

• The clerks who were associated with the preparation of wage sheets should not
take part in the payment of wages. (To avoid collusion)
• The use of envelopes indicating the number of workers and amounts contained
can be suitable medium for making payments.
• All workers who have to receive wages should be present at the time of
payment. (Signatures should be taken)
• The foreman of each department should be present at the time of payment.
• Proper precaution should be taken to make payments to workers who are absent
at that time.

CASH PURCHASE

Internal check as regards to Cash Purchase

1. Supply of purchase requisition: Whenever goods are required in any department of

the company, the head of department should send the purchase requisition to the
purchases department. He should mention quality, quantity of the item and time by
which the goods must be supplied.
2. Purchase order: It should be given in writing. It should be given on printed and
numbered forms. It should be recorded in the purchase book.
3. Copies of purchase order: There should be 3 copies of each purchase order. 1 copy
should be sent to suppliers. 1 copy to the store clerk and 1 should remain with purchases
department.
4. Writing goods received note (GRN): When the goods will be received, the store
department will make an actual inspection by counting or weighing. The person
receiving will write the particulars on the goods received note in duplicate.
5. Comparisons: 1 copy of the received goods note will be sent to the purchase
department. The purchase department will compare the quality and quantity with the
invoice.
6. Invoice checking: Each invoice on receipt should be checked by responsible officer
with the purchase order that the price and quantity is correct and ensure that there are
no variations.
Principles and Practice of Auditing

7. Purchase return: In case of any defect, it should be immediately reported to the

purchase department Purchase department may take up the case. They have to prepare
debit note and send it to the seller.
8. Payment: A responsible officer should pass on the payment of invoices. Before signing
the cheque, he should assure himself about the correctness of the account.

CASH SALES

Internal check as regards to Cash Sales

A. Sales over the Counter (cash)

B. Sales over postal (Delivery)
C. Sales through traveling Agent (salesmen)

A. Sales over the Counter (cash)

• Counter sales book: The salesman can sell products over the counter. The
sales book can be prepared on the basis of cash memos issued by the staff.
• No cash handling: The sales staff should not handle cash. All cash receipts
must be handed over to the cashier and accountant can make entries in the
books of accounts.
• Checking of copies: The internal auditor can check carbon copies of cash sales.
The copies can be used as a basis for determining total sales of a particular
period.
• Receipt of goods: The goods are handed over to the customer along with cash
memos. The officer of sales must check and sign the cash memo at time of
delivery of goods.
• Sales summary: The sales summary must be prepared and sent to sales
manager. The total sales must tally with the cash received from the customers.
• Cash verification: The sales officer can check the cash memo for the day. Th
cash collected must tally with the cash memo as well as total sales summary
for the day.
• Cash deposits: The cashier should not deposit the cash into bank account; total
cash must be handed over to the accountant who should make arrangement
depos for cash.
Principles and Practice of Auditing

• Sales discount: The sales discount rate can be examined from the price list
discount must not be in excess of the rules stated in the list. The discount
allowed should be posted to the sales discount accounts.
B. Sales over postal (Delivery)
• A separate register should be maintained for sales made by post, it is termed as
VPP (value payable by post) register.
• The goods returned by customer in case of defects or any related issues should
also be recorded in VPP register.
• Total receipts from customer on this a/c should be entered in VPP register.
• Any advance money received from customer should also be recorded in in VPP
register.
C. Sales through traveling Agent (salesmen)
• Travelling agent should be allowed to issue rough receipts to the customers for
cash received on the sales, final or original receipts should be issued from the
head office only.
• Agent should remit the entire proceeds to the head office or they should deposit
the cash daily in a bank.
• Agents should not be allowed to deduct their commission out of sale proceeds
collected by them.
• The agents should be asked to submit their periodical statement of sales and
such statements should be checked in detail.
• Head office should maintain a list of debtors and other customers who have not
cleared their debts.