RIZALTECHNOLOGICALUNIVERSITY

Cities of Mandaluyong and Pasig

CHAPTER 17
INTERNAL CONTROL AFFECTING LIABILITIES AND EQUITY

INTERNAL CONTROL OVER ACCOUNTS PAYABLE (TUPAZ)

The term accounts payable (often referred to as vouchers payable for a voucher system) is used to
describe short-term obligations arising from the purchase of goods and services in the ordinary course of
business. Typical transactions creating accounts payable include the acquisition on credit of
merchandise, raw materials, plant assets and office supplies.

Other sources of accounts payable include the receipt of services, such as legal and accounting
services, advertising, repairs and utilities. Interest-bearing obligations should not be included in accounts
payable but shown separately as bonds, notes, mortgages, or installment contracts.

Invoices and statements form supplies usually evidence accounts payable arising from the
purchase of goods and services and most other liabilities. However, accrued liabilities (sometimes called
accrued expenses) generally accumulate over time, and management must make accounting estimates of
the year-end liability. Such estimates are often necessary for salaries, pension, interest, rent, taxes and
similar items.

In thinking about internal control over accounts payable, it is important to recognize that the
accounts payable of one company are the accounts receivable of other companies. If follows that there is
little danger of errors being overlooked permanently since the client’s creditors will generally maintain
complete records of their receivables and will inform the client if payment is not received. This feature
also aids auditors in the discovery of fraud, since the perpetrator must be able to obtain and respond to
the demands for payment. Some companies, therefore, may choose to minimize their record keeping of
liabilities and to rely on creditors to call attention to any delay in making payment. This viewpoint is not
an endorsement of inaccurate or incomplete records of accounts payable, but merely recognition that the
self-interest of creditors constitutes an effective control in accounting for payables that is not present in
the case of accounts receivable.

Discussion of internal control applicable to accounts payable may logically be extended to the
entire purchase or acquisition cycle.
 RIZALTECHNOLOGICALUNIVERSITY
Cities of Mandaluyong and Pasig
Potential Misstatements – Accounts Payable (TUPAZ)
Description of Misstatement
Inaccurate recording of a
purchase or disbursement
Misappropriation of purchases
Duplicate recording of purchases
Late (early) recording of cost of
purchase – “cutoff problems”
Examples
Fraud:
 A bookkeeper prepares a
check to himself and
records it as having been
issued to a major supplier.
Error:
 A disbursement is made to
pay an invoice for goods
that have not been
received.
Fraud:
 Goods are ordered but
delivered to an
inappropriate address and
stolen
Error:
 A purchase is recorded
when an invoice is
received from a vendor
and recorded again when
a duplicate invoice is sent
by the vendor.
Fraud:
 Purchases journal “closely
early” with this period’s
purchase recorded as
having occurred in
subsequent period.
Internal Control Weakness or
Factors that Increase the Risk
of the Misstatements
 Inadequate segregation of
duties of record keeping
and preparing cash
disbursements, or check
signer does not review
and cancel supporting
documents.
 Ineffective controls for
matching invoices with
receiving documents
before disbursement are
authorized.
 Ineffective controls for
matching invoices with
receiving documents
before disbursement are
authorized.
 Ineffective controls for
review and cancellation of
supporting documents by
the check signer.
 Ineffective board of
directors, audit
committee, or internal
audit function; “tone at
the top” not conducive to
ethical conduct; undue
pressure to meet earnings
target.
 RIZALTECHNOLOGICALUNIVERSITY
Cities of Mandaluyong and Pasig

INTERNAL CONTROL OVER OTHER DEBTS (TUAZON)

Business corporations obtain substantial amounts of their financial resources by incurring debt
and issuing capital stock. The acquisition and repayment of capital is sometimes referred to as the
financing cycle. This transaction cycle includes the sequence of procedures for authorizing, executing, and
recording transactions that involve bank loans, mortgages, bonds payable, and capital stock as well as the
payment of interest and dividends.

Internal Control over Debt

Authorization by the Board of Directors (TUAZON)

Effective internal control over debt begins with the authorization to incur the debt. The bylaws of
a corporation usually require that the board of directors approve borrowing. The treasurer of the
corporation will prepare a report on any proposed financing, explaining the need for funds, the estimated
effect of borrowing upon future earnings, the estimated financial position of the company in comparison
with others in the industry both before and after borrowing, and alternative methods of raising funds.
Authorization by the board of directors will include review and approval of such matters as the choice of
a bank or trustee, the type of security, registration with SEC, agreements with investment bankers,
compliance with requirements of the state of incorporation, and listing of bonds on a securities exchange.
After the issuance of long-term debt, the board of directors should receive a report stating the net
amount received and its disposition as, for example, acquisition of plant assets, addition to working
capital, or other purposes.

Use of an Independent Trustee (TUAZON)

Bond issues are always for large amounts – usually many millions of pesos. Therefore, only
relatively large companies issues bonds: small companies obtain long-term capital through mortgage
loans or other sources. Any company large enough to issue bonds and able to find a ready market for the
securities will almost always utilize the services of a large bank as an independent trustee.

The trustee is charged with the protection of the creditors’ interest and with monitoring the
issuing company’s compliance with the provisions of the indenture. The trustee also maintains detailed
records of the names and addresses of the registered owners of the bonds, cancels old bond certificates
and issues new ones when bonds change ownership, follows procedures to prevent over issuance of bond
certificates, distribute interest payments, and distributes principal payments when the bonds mature.
Use of an independent trustee largely solves the problem of internal control over bonds payable. Internal
control is strengthened by the fact that the trustee does not have access to the issuing company’s assets
or accounting records and the fact that the trustee is a large financial institution with legal responsibility
for its actions.
 RIZALTECHNOLOGICALUNIVERSITY
Cities of Mandaluyong and Pasig

Interest Payments on Bonds and Notes Payable (VIDAL)

Many corporations assign the entire task of paying interest to the trustee for either bearer bonds
or registered bonds. Highly effective control is then achieved, since the company will issue a single check
for the full amount of the semiannual interest payment on the entire bond issue.

INTERNAL CONTROL OVER OWNER’S EQUITY (TOLENTINO)

The three principal elements of strong internal control over share capital and dividends:

1. The proper authorization of transactions by the board of directors and corporate office,
2. The segregation of duties in handling these transactions (preferably the use payments), and
3. The maintenance of adequate records.

Internal Control on Equity

Control of Share Capital Transactions by the Board of Directors (TOLENTINO)

All changes in share capital accounts should receive formal advance4 approval by the board of
directors. The board of directors must determine the number of shares to be issued and the price per
share; if an installment plan of payment is to be used, the board must prescribed the terms. If plant and
equipment, services, or any consideration other than cash is to be accepted in payment for shares, the
board of directors must establish the valuation on the noncash assets received. Transfers from retained
earnings to the Share Capital and Paid-in Capital accounts, as in the case of stock dividends, are initiated
by action of the board. In addition, stock splits the changes in par or stated value or shares require formal
authorization by the board.

Authority for all dividend actions rests with the directors. The declaration of a dividend must
specify not only the amount per share but also the date of record and the date of payment.

Independent Registrar and Stock Transfer Agent (TOLENTINO)

In appraising internal control over share capital, the first question that the auditors consider is
whether the corporation employs the services of an independent share registrar and a share transfer
agent or handles its own capital share transactions. Internal control is far stronger when the services of
an independent share registrar and a stock transfer agent are utilized because the banks or trust
companies acting ion these capacities will have the experience, the specialized facilities, and the trained
personnel to perform the work in an expert manner. Moreover, by placing the responsibility for handling
share capital certificates in separate and independent organizations, the corporation achieves to the
fullest extent the internal control concept of separation of duties.
 RIZALTECHNOLOGICALUNIVERSITY
Cities of Mandaluyong and Pasig

Internal Control over Dividends (VIDAL)

The nature of internal control over the payment of dividends, as in the case of stock issuance,
depends primarily upon whether the company performs the function of dividend payment itself or
utilizes the services of an independent dividend-paying agent. If an independent dividend-paying agent is
used, the corporation will provide the agent with a certified copy of the dividend declaration and a check
for the full amount of the dividend. The bank or trust company serving as stock transfer is usually
appointed to distribute the dividend, since it maintains the detailed records of shareholders. The agent
issue dividend checks to the individual shareholders and sends the corporation a list of the payments
made. The use of an independent fiscal agent is to be recommended from the stand-point of internal
control, for it materially reduces the possibility of fraud or error arising in connection with the
distribution of dividends.

In a small corporation that does not use the services of a dividend-paying agent, the responsibility
for payment of dividends is usually lodged with the treasurer and the secretary. After declaration of a
dividend by the board of directors, the secretary prepares a list of shareholders as of the date of record,
the number shares held by each, and the amount of the dividend each is to receive. The total of these
individual amounts is proved by multiplying the dividend per share by the total number of outstanding
shares.

Dividend checks controlled by serial numbers are dawn payable to individual stockholders in the
amount shown on the list described above. If the shareholders ledger is maintained on a computer
master file, the dividend checks may be prepared by the computer directly from this record. The
stockholder list and dividend checks are submitted to the treasurer for approval and signature. The
checks should be reconciled by the treasurer with the total of shares outstanding and mailed without
again coming under control of the officer who prepared them.

Cash in the amount of the total dividend is then transferred from the general bank account to a
separate dividend bank account. As the individual dividend checks are paid from this account and
returned by the bank, they should be matched with the check stubs or marked paid in the dividend check
register. A list of outstanding checks be prepared monthly from the open stubs or open items in the
checks register. This list should agree in total with the balance remaining in the dividend bank account.
Companies with numerous shareholders prepare dividend checks in machine-readable form, so that the
computer may perform the reconciliation of outstanding checks.
 RIZALTECHNOLOGICALUNIVERSITY
Cities of Mandaluyong and Pasig

REVIEW QUESTIONS
1. What are the relevant accounts related to debt obligations?
2. What are the relevant accounts related to stockholders’ equity transactions?
3. Identify common transactions affecting stockholders’ equity accounts.
4. Identify fraud risks associated with debt obligations.
5. Identify fraud risks associated with stockholders’ equity accounts.