Accounting and Administrative Control Systems

Internal Control
Could there be dishonest employees where you work? Unfortunately, the answer sometimes is Yes. For
example, in addition to the highly publicized frauds at Enron, WorldCom, Tyco, and Global Crossing, the
financial press recently reported the following.

 A bookkeeper in a small company diverted $750,000 of bill payments to a personal bank account
over a 3-year period.
 A shipping clerk with 28 years of service shipped $125,000 of merchandise to himself.
 A computer operator embezzled $21 million from Wells Fargo Bank over a 2-year period.
 A church treasurer "borrowed" $150,000 of church funds to finance a friend's business dealings.
These situations emphasize the need for a good system of internal control.

Internal control consists of the plan of organization and all the related methods and measures adopted within
a business to:

1. Safeguard its assets from employee theft, robbery, and unauthorized use.

2. Enhance the accuracy and reliability of its accounting records. This is done by reducing the risk of errors
(unintentional mistakes) and irregularities (intentional mistakes and misrepresentations) in the accounting
process.

Principles of Internal Control

To safeguard its assets and enhance the accuracy and reliability of its accounting records, a
company follows specific control principles. Of course, internal control measures vary with the
size and nature of the business and with management’s control philosophy. The six principles,
listed below, apply to most enterprises.
 Establishment of responsibility
 Segregation of duties
 Documentation procedures
 Physical, mechanical and electronic controls
 Independent internal verification
 Other controls
Establishment of Responsibility

An essential characteristic of internal control is the assignment of responsibility to specific employees. Control
is most effective when only one person is responsible for a given task. To illustrate, assume that the cash on
handItsat
yourthe endI’mof the day in a Safeway supermarket is $10 short of the cash rung up on the cash register. If
shift now.
turning in my cash drawer
only and
one person
heading home has operated the register, responsibility for the shortage can be assessed quickly. If two or
more individuals have worked the register, it may be impossible to determine who is responsible for the
error unless each person is assigned a separate cash drawer and register key.

Establishing responsibility includes the authorization and approval of transactions. For example, the vice
president of sales should have the authority to establish policies for making credit sales. The policies ordinarily
will require written credit department approval of credit sales.

Transfer of cash drawers

Segregation of Duties
Segregation of duties (also called separation of functions or division of work) is indispensable in a system of
internal control. There are two common applications of this principle:

1. Related activities should be assigned to different individuals.

2. Establishing the accountability (keeping the records) for an asset should be separate from the physical
custody of that asset.
The rationale for segregation of duties is this: The work of one employee should, without a duplication of
effort, provide a reliable basis for evaluating the work of another employee.

R E L A T E D A C T I V I T I E S . Related activities that should be assigned to different individuals arise in both

purchasing and selling. When one individual is responsible for all of the related activities, the potential for
errors and irregularities is increased. Related purchasing activities include ordering merchandise, receiving
the goods and paying (or authorizing payment) for the merchandise. In purchasing, for example, orders, could
be placed with friends or with suppliers who give kickbacks. Or, only a cursory count and inspection could be
made upon receiving the goods, which could lead to errors and poor-quality merchandise. Payment might
be authorized without a careful review of the invoice. Even worse, fictitious invoices might be approved for
payment. When the ordering, receiving, and paying are assigned to different individuals, the risk of such
abuses is minimized.

Similarly, related sales activities should be assigned to different individuals. Related selling activities include
making a sale, shipping (or delivering) the goods to the customer, billing the customer, and receiving
payment. When one person handles related sales transactions, a salesperson could make sales at unauthorized
prices to increase sales commissions; a shipping clerk could ship goods to himself; a billing clerk could
understate the amount billed for sales made to friends and relatives. These abuses are reduced by dividing
the sales tasks: the salespersons make the sale; the shipping department ships the goods on the basis of
the sales order; and the billing department prepares the sales invoice after comparing the sales order with
the report of goods shipped.

Accounting Employee A

Maintains cash
balances per books

Assistant Cashier B

Maintains custody

A C C O U N T A B I L I T Y F O R A SS ETS . To provide a valid basis of accountability for an asset, the accountant should
have neither physical custody of the asset nor access to it. Likewise, the custodian of the asset should not
maintain or have access to the accounting records. When one employee maintains the record of the asset
that should be on hand, and a different employee has physical custody of the asset the custodian of the asset is
not likely to convert the asset to personal use. The separation of accounting responsibility from the custody of
assets is especially important for cash and inventories because these assets are very vulnerable to unautho-
rized use or misappropriation.

Documentation Procedures
Documents provide evidence that transactions and events have occurred. A cash register tape is
documentation for the sale and the amount of cash received. Similarly, the shipping document indicates that
the goods have been shipped, and the sales invoice indicates that the customer has been billed for the
goods. By adding signatures (or initials) to the documents, the individual(s) responsible for the transaction
or event can be identified. Documentation of transactions should be made when the transaction occurs.
Documentation of events, such as those leading to adjusting entries is generally developed when the
adjustments are made.
Several procedures should be established for documents. First, whenever possible, documents should be
prenumbered, and all documents should be accounted for. Prenumbering helps to prevent a transaction from
being recorded more than once It also helps to prevent the transactions from not being recorded. Second,
docments that are source documents for accounting entries should be promptly forwarded to the accounting
department. This control measure helps to ensure timely recording of the transaction and contributes directly
to the accuracy and reliability of the accounting records.

Pre-numbered invoices

Physical, Mechanical, and Electronic Controls

Use of physical, mechanical, and electronic controls is essential. Physical controls relate primarily to the
safeguarding of assets. Mechanical and electronic controls also safeguard assets; some enhance the accuracy
and reliability of the accounting records. Examples of these controls are shown in illustration 7.

Illustration 7

Physical, mechanical, and

Physical Controls
Safes, vaults, and safety Locked warehouses and Computer facilities
deposit boxes for cash storage cabinets for with pass key access
and business papers inventories and records or fingerprint or
eyeball scans

Mechanical and Electronic Controls

Alarms to prevent Television monitors Time clocks for

break-ins and garment sensors recording time worked
to deter theft
Independent Internal Verification
Most internal control systems provide for independent internal verification. This principle involves the
review, comparison, and reconciliation of data prepared by other employees. To obtain maximum benefit
from independent internal verification:

1. The verification should be made periodically or on a surprise basis.

2. The verification should be done by someone who is independent of the employee responsible for the
information.
3. Discrepancies and exceptions should be reported to a management level that can take appropriate
corrective action.
Independent internal verification is especially useful in comparing recorded accountability with existing assets.
The reconciliation of the cash register tape with the cash in the register is an example of this internal control
principle. Another common example is the reconciliation by an independent person of the cash balance per
books with the cash balance per bank. The relationship between this principle and the segregation of
duties principle is shown graphically in Illustration 9.

In large companies, independent internal verification is often assigned to internal auditors. Internal auditors
are company employees who evaluate on a continuous basis the effectiveness of the company's system of
internal control. They periodically review the activities of departments and individuals to determine
whether prescribed internal controls are being followed. They also recommend improvements when
needed. The importance of this function is illustrated by the fact that most fraud is discovered by the
company through internal mechanisms, such as existing internal controls and internal audits. The recent
alleged fraud at WorldCom involving billions of dollars, for example, was uncovered by an internal auditor.

Illustration 8

Comparison of segregation Segregation

of duties principle with of Duties
independent internal

Accounting Employee A Assistant Cashier

Maintains cash Maintains custody

balances per books

Independent Internal

Verification
Assistant Treasurer C

Makes monthly comparisons; reports any

irreconcilable differences to treasurer
 Other Controls

If I take a vacation

they will know that

Other control measures include the following.

1. Bonding of employees who handle cash. Bonding involves obtaining insurance protection against
misappropriation of assets by dishonest employees. This measure contributes to the safeguarding of
cash in two ways: First, the insurance company carefully screens all individuals before adding them to
the policy and may reject risky applicants. Second, bonded employees know that the insurance company
will vigorously prosecute all offenders.

2. Rotating employees' duties and requiring employees to take vacations. These measures are designed to
deter employees from attempting any thefts since they will not be able to permanently conceal their
improper actions. Many bank embezzlements, for example, were discovered when the perpetrator was on
vacation or assigned to a new position.
Limitations of Internal Control
A company's system of internal control is generally designed to provide reasonable assurance that assets
are properly safeguarded and that the accounting records are reliable. The concept of reasonable
assurance rests on the premise that the costs of establishing control procedures should not exceed their
expected benefit. To illustrate, consider shoplifting losses in retail stores. Such losses could be
eliminated by having a security guard stop and search customers as they leave the store. But, store
managers have concluded that the negative effects of adopting such a procedure cannot be justified.
Instead, stores have attempted to "control" shoplifting losses by less costly procedures such as: (1)
posting signs saying, "We reserve the right to inspect all packages," and "All shoplifters will be
prosecuted," (2) using hidden TV cameras and store detectives to monitor customer activity, and (3)
using sensoring equipment at exits.

The human element is an important factor in every system of internal control. A good system can
become ineffective as a result of employee fatigue, carelessness or indifference. For example, a
receiving clerk may not bother to count goods r e ceived or may just "fudge" the counts. Occasionally,
two or more individuals may work together to get around prescribed controls. Such collusion can
significantly impair the effectiveness of a system, eliminating the protection offered by segregation of
duties. If a supervisor and a cashier collaborate to understate cash receipts, the system of internal
control may be negated (at least in the short run). No system of internal control is perfect.

The size of a business may impose limitations on internal control. In a small company, for example, it
may be difficult to segregate duties or to provide for independent internal verification.

Cash Controls

Just as cash is the beginning of a company's operating cycle, it is also usually the starting point for a
company's system of internal control. Cash is the one asset that is readily convertible into any other
type of asset. It is easily concealed and transported, and it is highly desired. Because of these
characteristics, cash is the most susceptible to improper diversion and use. Moreover, because of the
large volume of cash transactions, numerous errors may occur in executing and recording them. To
safeguard cash and to ensure the accuracy of the accounting records for cash, effective internal
control over cash is imperative.

Internal Control over Cash Receipts

Cash receipts come from a variety of sources: cash sales; collections on account from customers; the
receipt of interest, rent, and dividends; investments by owners; bank loans; and proceeds from the
sale of noncurrent assets. Illustration 9 shows how the internal control principles explained earlier
apply to cash receipts transactions.

As might be expected, companies vary considerably in how they apply these principles. To illustrate
internal control over cash receipts, we will examine measures for a retail store.
Control of over-the-counter receipts in retail businesses is centered on cash registers that are visible
to customers. In supermarkets and in variety stores such as Kmart, cash registers are placed in check-
out lines near the exit. In stores such as Sears, Roebuck & Co. and J. C. Penney, each department has its
own cash register. A cash sale is "rung up" on a cash register with the amount clearly visible to the
customer. This measure prevents the cashier from ringing up a lower amount and pocketing the
difference. The customer receives an itemized cash register receipt slip and is expected to count the
change received. A cash register tape is locked into the register until removed by a supervisor or
manager. This tape accumulates t h e daily transactions and totals. When the tape is removed, the
supervisor compares the total with the amount of cash in the register. The tape should show all registered
receipts accounted for. The supervisor's findings are reported on a cash count sheet which is signed
by both the cashier and supervisor.

The count sheets, register tapes, and cash are then given to the head cashier. This individual prepares a
daily cash summary showing the total cash received and the amount from each source, such as cash
sales and collections on account. The head cashier sends one copy of the summary to the accounting
department for entry into the cash receipts journal. The other copy goes to the treasurer's office for
later comparison with the daily bank deposit.

Next, the head cashier prepares a deposit slip (see Illustration 10) and makes the bank deposit. The
total amount deposited should be equal to the total receipts on the daily cash summary. This will
ensure that all receipts have been placed in the custody of the bank. In accepting the bank deposit,
the bank stamps (authenticates) the duplicate deposit slip and sends it to the company treasurer, who
makes the comparison with the daily cash summary.

Illustration 9

Application of internal
control principles to cash

Internal Control over Cash Receipts

Establishment of Physical,
Responsibility
Mechanical, and
Only designated
personnel are Electronic Controls
authorized to
handle cash receipts Store cash in safes and
(cashiers) bank vaults; limit access
to storage areas; use

Segregation of
Duties
Different individuals
receive cash, record
;cash receipts, and hold
the cash
Independent
Internal
Verification
Supervisors count cash
receipts daily;
treasurer compares
total receipts to bank

Other Controls
Documentation
Procedures Bond personnel who
handle cash; require
Use remittance employees to take
advice (mail vacations; deposit all
cash in bank daily
receipts), cash
Illustration 10

Executing over-the-counter cash sales

Internal Control over Cash Disbursements

Cash may be disbursed for a variety of reasons, such as to pay expenses and liabilities, or to purchase assets.
Generally, internal control over cash disbursements is more effective when payments are made by cheque,
rather than by cash. One exception is for incidental amounts that are paid out of petty cash. Payment by
cheque generally occurs only after specified control procedures have been followed. In addition, the
"paid" cheque provides proof of payment. Illustration 11 shows how principles of internal control apply to
cash disbursements.

Illustration 11

Internal Control over Cash

Disbursements

Establishment of Physical,
Responsibility
Mechanical, and
Only designated
personnel are Electronic Controls
authorized to sign
cheques (treasurer) Store blank cheques in
safes, with limited
access; print cheque

Independent
Segregation of
Duties internal
Verification
Different individuals
approve and make Compare cheques to
payments; cheque invoices; reconcile
signers do not record bank statement
disbursements

Documentation Other Controls

Procedures
Stamp invoices
Use prenumbered PAID
cheques and account
for them in sequence;
each cheque must have
approved invoice
Internal Control over Inventory
Security guards. They are used to prevent the unauthorized removal of goods from business
premises. Persons taking goods from the compound should have documents indicati ng the
permission to do so. Without documentation one can consider the activity illegal.

Perimeter fence. This is particularly necessary where bulky goods are kept in a stockyard. It
prevents easy access by unauthorized persons and vehicles to such material. The transfer of stock
from this area should have the necessary documentation.

Administration. This is the unit that is responsible for the preparation and storage of documents
and data. The purchasing department places the order, the receiving section accepts the invoice
and the accounti ng department when reliably informed pays for the order. Reports from each
of these areas when matched will ensure that all stock is accounted for.

Identi ty badges. In large organizations when persons in administration have to enter factories
and warehouses they usually have to produce some form of identification. This may give them the
right to audit but not transfer goods into or out of these areas. The movement of goods is the
portfolio of the authorized agent only. Such restricted entry will minimize pilfering.

Locked warehouse. The transfer of goods into warehouses is usually monitored and documented
by administration and verified by the stores manager. When materials are transferred to the
factory to be used in production the manager of stores becomes accountable for the issue of
such material which will be verified by the factory manager. The report on material used by the
factory should match the report prepared by the warehouse manager. Stock levels are further
monitored by physical stock checks and eventually by stock reports.

Controlling Accounts Receivable

Credit sales created the reality of bad debts or uncollectable accounts receivable. A well-managed
company will screen its potential credit customers by obtaining information about them, to
determine their ability to pay their debts.

Accounts receivable is an asset which is susceptible to fraudulent interference within the firm. It is
important therefore that the internal control principle of separation of duties among the staff is
strictly adhered to. The employees who maintain accounts receivable files should not have custody of
cash. The employees who handle cash, receipts and accounts receivable have no authority to issue
credit memoranda or authorize which accounts receivable should be written off.

Procedures for Controlling Accounts Receivable

A summary of internal control systems for accounts receivable should include:

1. Interview potential credit customers and ascertain information to ensure credit worthiness and
 ability to repay debts.

2. Authorization of credit to customers only by the credit supervisor.

3. Sale of goods on credit only with proper documentation by sales personnel; i.e. sales invoice.

4. Entry of debt into the accounts receivable book by the accounts receivable clerk, using the sales
invoice received from the sales department.

5. Collection by the sales return department of goods returned by credit customers, and the issue
of a credit note document to the accounts department.

6. Collection of cash by cashier from credit customers and the issue of receipt to customer and copy
to accounts receivable clerk.

7. Entry of receipt in the accounts receivable book, only by the accounts receivable clerk.

8. Checking of documents and books by internal auditor to verify accuracy and consistency of information
among departments.

Controlling Accounts Payable

Competent personnel. One of the first steps in instituting a control system for accounts payable is
to ensure that those charged with particular responsibilities have a high level of ethical conduct
developed either from personal experience or from the business code practiced by the entity. The
competence of the employee should be supported by the ability to keep information confidential.
The employee's competence is often reflected in the degree to which the worker can be objective
in the execution of his duties. The unwillingness to compromise integrity goes a long way in
testifying for the worker's ability. The system can become very effective when an employee is
responsible for a single task.

Separation of duties. From the receiving department to the accounting department no one
person is charged with two or more distinct responsibilities when dealing with accounts payable.
This is ideal for an effective control system, as it would take a significant number of persons and a
host of different positions to corrupt the procedure. Effectiveness is achieved by assigning related
activities to different individuals and ensuring that the recording of information on an asset is
separated from the custody of the asset. When duties are separated in this way the efforts of one
employee act as checks and balances on another employee and reduce the possibilities of errors
and irregularities.

Documentation. The written word supported by authorized authentic signatures if proof is

required that an activity took place. The purchasing department will have a statement of what
was requested and ordered. The supplier will have documentary proof of what was ordered
and supplied. The accounts department will have a purchase report of what was received and
cheque (stubs) indicating the amount paid.
Accounting records tend to be more accurate and reliable when documents are pre-
numbered. The paperwork for accounts is more efficient in preventing omission or duplication
of entries. Should there be any attempt to breach the control system the greater part of the
paper trail will have to be interrupted.

Independent internal verification. When a business has a large number of persons and
organizations to pay, mistakes can be frequent. Hence it is necessary to review and compare
reports the workers prepare. Very often there will be disagreement making reconciliation
necessary.

For a control system for accounts payable to be efficient it must entail periodic verification done
by someone who is not involved in the performance of the routine. To ensure that irregularities
are arrested immediately deviations from the accepted practice should be reported to the
relevant authorities and action taken.

Proper authorization. In its simplest form this can range from giving employees clear responsibilities
to having two signatures to a document to confining an employee to signing a document up to a
certain amount in value. 'Depending on the size of the enterprise the amounts for accounts payable
can range from two to six digits. Small amounts can he overseen by clerks and larger amounts by
clerks and managers, each providing a signature. This arrangement serves to prevent the clerk being
overwhelmed by the figures and the manager compromising his integrity.

Rotation of employees. The positive side to rotating employees is that they will become
knowledgeable about other departments of the business. A second reason is lo prevent employees
from falling prey to temptation when they become entrenched in a job. It is hoped that shortening
an employee's stay in a particular office will reduce the probability of establishing contacts with
creditors or accountants to defraud the enterprise of cash.

Internal Controls in an Electronic Data Processing Environment

Physical security. This is the most common form of security and its purpose is merely to prevent
unauthorized persons from having access to the equipment. It can range from simple lock and key
to using security guards with an electronic security system, e.g. passwords/passnumbers.

Software to create documents. The activities at the business place might range from letter writing
to analysis of financial information. There is software to simplify and speed up the process. However,
before software can be adopted it is advisable to evaluate the source for trustworthiness. Further
investigation should also determine if it is bug-infected as this may ultimately affect the creation of
documents.

Direct data security. Information must be tailored to suit the profile of the user. For example,
whereas the purchasing manager might need to have information on sales, it will be unnecessary
for him to have data on accounts receivable. Hence he may be denied access to such iniormation.

Access level. How much information should the accounts clerk be allowed to have access to? The wages
and salaries clerk may be able to see the salaries up to supervisory level but not be allowed to view
the salaries of managers.

View rights. An important decision that must be made is whether the viewer of the information
should have the right to add or delete data on himself or others.

Back-ups. The possibility of accidents or natural disasters dictates that there be alternative ways for
securing information. A hard copy must be kept to ensure that data on the hard drive is not lost.
Data can also be stored at an off-site venue to prevent total loss of information.

Archiving. Electronic filing systems can store a great amount of information and there might be the
tendency to retain even that which is obsolete. A decision must be made as to how long to keep any
set of data and to ensure that relevant data are not deleted.

Role of the Auditors

One of the most effective forms of administrative control that an organization can pursue is that of
financial audits. These are detailed examinations of the relevant documents and financial statements
of the organization at the end of the period. They include tests which will verify the reliability and
validity of the accounting principles used in producing the financial reports.

These financial audits are conducted by mandate, through independent external auditors.
Prior to the external auditor's examination, most organizations would have conducted ongoing
internal audits, whereby the company's operations are reviewed by independent internal auditors to
ensure compliance to management's policies, and an overall assessment of the efficiency of the
company's operation. Their tasks will also include ensuring that an effective internal control system
is maintained.

The features of an organization's internal and external auditors can be compared and summarized
using the following table:
 The Internal and External Auditors Compared

Internal External

Appointment Hired by manager Hired by shareholders through the board

of directors.

Relationship Usually an employee of the company Hired for the special assignment and may
hired on a permanent basis. use the work of the internal auditors.

Scope of work Looks at efficiency and effectiveness Examines records to ensure that
and allegations of fraud. appropriate laws, regulations and policies
are followed.

Rules to follow Responsibilities decided by Application of international accounting

management standards and guidelines.

Types of report Strengths and weaknesses of the Expresses an opinion of presentation and
system and makes recommendations. control based on a fixed format.

Frequency Quarterly or as needed Annually.

Qualification Can be trained internally. Qualified professionals.

Accountable to Board of directors. Shareholders.

Responsibility Decided by management. Fixed by company law and legislation and

not responsible for preventing and
detecting fraud.

Operations Works objectively and independently of Works independently of the corporation

employees but dependent on the and management.
organization.

Impact of Technology on Accounting

Computerize Manual

Accuracy Errors are minimized Tendency to make errors

Subjectivity Lower level of subjectivity Higher level of subjectivity

Detecting mistakes Easily detected Difficult and time-consuming

Information storage and Software available to hasten process Time-consuming

retrieval
Security of information Protected by password, encryption Limited to physical security
code, firewalls etc.

Skill needed Must know computer basics Training in the field

Recording frequency Less frequently To be done daily to avoid backlog

Processing volume Short completion time Heavy workload

Processing speed Analyses quickly Needs more time

Cost High initial cost that reduces over High constant cost because of
time manual labour