Chapter No.

02
Internal control
 What is internal control?
According to ISA:
Internal control means the policies and procedures
adopted by the management for systematic and
efficient conduct of its business, including:
• observance to management policies,
• safe guarding of assets,
• the prevention and detection of fraud and errors,
• the accuracy and completeness of the accounting
records , and
• the timely preparation of reliable financial
information.
 Objectives of internal control
1.Protection of assets
2.Maintaining accurate accounting records.
3.Following accounting policies
4.Prevention of errors
5.Prevention of frauds
6. Best use of resources
7.To determine the nature and scope of external
audit
8.To maintain reliable accounting records.
 Principles of Internal control
1.Sufficient staff should be there to cover work
load.
2.Trained staff should be there to increase
efficiency.
3.Division of duties should be on the basis of
staff abilities.
4.Accounting records should be kept simple as
far as possible
5.Rotation of duties is a principle of internal
control to improve efficiency and avoiding the
chances of frauds.
6. Division of labor encourages specialization.
7.Subsidiary records are used to reconcile the
control accounts with individual details.
8.Physical assets should be reconciled against
books at the end of a specific period.
9. One person should not allowed to do every
aspect of transaction. Everyone should
dependent upon others to perform his duties.
10. Supervisory control is necessary to make
business effective.
11. Internal audit is also part of internal control
to keep check on activities.
12. Use of computers can reduce the errors and
mistakes.
 Evaluation of internal control
A. Compliance Procedures:
– The compliance testing procedures are tests
designed to obtain reasonable assurance that
these internal controls on which audit reliance is
to be placed are in effect.
– Compliance procedures can be applied with the
help of audit sampling. The samples can be
selected from various categories of transactions in
order to test the control aspect.
• Compliance testing techniques:
– Examination of evidence:
• The inspection of records, documents and report is an
examination of evidence.
– Computation:
• There may be computation of figures again which the
employees worked out.
– Observation:
• The auditors can observe the physical security of store,
examination of coming goods and control over
counting of goods.
– Custody:
• The inquiry and observation are the basic tools to test
the custodial control
– Segregation of duties:
• Compliance procedure can be applied to test that
classification of duties are properly done or not.
– Supervision:
• The compliance procedures depend upon supervisory
control. The examination of evidence is the basic tool
to test that supervisory control is effective or not.
 Example: Compliance test
• Compliance test relating to purchases has been given.
The auditor can test:
– Arrangement of purchase order
– Approval of purchase order
– Authority limits of purchase orders
– Arrangement of goods received record.
– Placement of goods returned records.
– Authorization of adjustments to purchase ledger balances.
– Numbering of purchase invoices.
– Arrangement of purchase invoices.
– reconciliation between purchase orders and
goods received notes and purchase invoices.
– Reconciliation between goods returned record
and credit note.
– Checking calculation of purchase invoices.
– Coding of purchase invoices
– Separation of sales taxes.
– Approval purchase invoices for accounting system.
B. Substantive procedures
Substantive procedures are designed to obtain evidence as to
completeness, accuracy and validity of data produced by the
accounting system. They are two types:

a. Test of details transactions and balances.

– If internal control is week then test of detail transactions are used.

b. Analysis of significant ratios and trends:

– If internal control is strong then the auditor can use ratios and
trends to form an opinion.
Internal control for small concerns
• Correspondence
– All incoming correspondence should be opened by a
responsible officer.
• Remittances and deposits
– All remittances and in the form of cheques, drafts etc
should be crossed and marked ‘‘ accounts payee
only’’ and deposited into the bank on the next day.
• Payment authorization
– All payments should be sanctioned by responsible
officers.
• Wages and salaries
– Wages and salary book should be carefully
checked and payments made in the presence of
the person who knows labourers and clerks.
• Goods
– A complete record of all goods received and sent
out should be maintained and physical count
should be carried out at regular intervals.
 Manufacturing Concerns
• Access to ledgers
– The cashier should have no access to the ledgers
and ledger keepers should not maintain the books
of original entry.
• Correspondence
– All incoming correspondence should be opened
by a responsible officer.
• Remittances and deposits
– All remittances and in the form of cheques, drafts
etc should be crossed and marked ‘‘ accounts payee
only’’ and deposited into the bank on the next day.

• Printed form:
– Official printed form should be used to issue
receipts and signed by responsible officer.
• Cash sales
– Cash sales should be carefully supervised
• Payment authorization
– All payments should be sanctioned by responsible
officers. All payments should be in cross cheques.
• Wages
– Payments of wages should be carefully supervised.
• Petty cash
– Petty cash book should kept on the imprest system.
• Purchases
– Purchases should be subject to proper control and all inward
invoices should be checked.
• Control accounts
– Sundry creditors ledger should be checked by control
accounts in the general ledger.
• Stock and stores
Periodical physical check should be carries out by a responsible
official.
 Cash Receipts
• The flexible rules should be followed as sound
system of internal check:
– Unused books should be kept under lock and key
– All receipts should be consecutively numbered.
– The issue and custody of receipts should be
retained and countersigned by a responsible
official.
– Acknowledgement of receipts should be obtained
so.
• Acknowledgement
– For every amount received official receipt should
be issued.
• Remittances Received
– all correspondence received must be opened by
a responsible official. All remittances received
must be crossed “ account payee only”.
• Deposits .
– All collections must be internally checked and
then deposited into the bank in the next day. Pay
in slips should be filed and checked daily.
• No access to ledgers
– The cashier should not be allowed any access to
personal or general ledgers.
• Teeming and lading
– The following steps should be taken to avoid
teeming and lading:
• The amount recorded should be compared against the
statement of account received from debtors.
• The debtors should be requested to give cross cheques
marked “account payee only”
• Physical count
– Surprise inspection of cash should be done by a
responsible official.
• Segregation
– All collections should be segregated and kept
separate.
 Cash payments
• Mode of payments
– As far as possible, payments must be made by
crossed cheques marked “accounts payee only”
and official receipt should be received.
• Authorization
– All payments should be authorized by a
responsible official duly vested with these powers
by the management.
• Recording
– All payments should promptly recorded in cash book.
• Vouchers
– All supporting vouchers of payment should be serially
numbered and filed in order to facilitate the
subsequent checking by auditor.
• General
– Arithmetical accuracy should be checked and bank
reconciliation should be prepared after specific
period to reconcile bank balance against cash book
balance.
 Petty cash transactions
• Imprest
– Petty cash book should be maintained and imprest
system should be kept in line with the actual
financial requirement.
• Payments
– Vouchers should be prepared for all payments
which should be authorized by a responsible
official.
• Allocation
– Before authorizing payment, allocations should be
checked carefully and all vouchers promptly
entered in the petty cash book.
• Reimbursement
– Periodical reimbursement of all payments should
be claimed and short fall in imprest may be
recovered.
• Cash count
– Cash in hand should be physical counted on
surprises basis by responsible official.
 Sales
• Orders received
Orders received should be confirmed in writing and recorded in order received book.
• Execution of orders
Orders should be executed within desired time & marked off from order received book.
• Invoices
Desire number of copies of invoices should be prepared & internally checked for rates,
goods and billing basis.
• Dispatch of goods
All dispatched goods should be recorded in the Goods Dispatch Register & matched
against invoices.
• Allocation
Allocation of sales should be verified.
• Receipt of money
A careful watch over collection of money against credit sales should be kept.
• Goods returned
All goods returned by customers should be entered in goods inward book and a credit
noted should be passed by responsible officials.
• Access to ledgers
The person making sales should have nothing to do with the office where sales ledgers
are posted up nor with the cashier office.
 Stores
Ordering level
The quantitative reorder level, maximum stock and minimum stock level should be set for
each type of item purchased.
Placing of order
Official order form should be sent to suppliers in respect of materials required and a copy
should be sent to store keeper.
Receipt of materials
Materials received should be checked by the store keeper with copies of purchase order and report as
quality, quantity and condition etc to buying department.
Storing of materials
All materials should be placed in appropriate racks, bins and should be entered on bin card to keep
perpetual record.
Record of materials
All materials received should be recorded in store ledger with quantity and value received and issued.
Issue of materials
Materials for use in production should be issued by the store keeper only on the authority of materials
requisition signed by the works manager or a responsible official.
Returns of materials
There should be rule that any material issued which is found to be surplus in a particular job should be
returned to the store.
End of chapter 2

Thank you!