Internal Control

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 Learning Outcome
• To be able to identify and illustrate objectives and basic
elements of internal control.

• To be able to prepare, describe and analyse the internal

control check list & internal control questionnaire

• To be able to prepare and analyse the internal control

procedure for cash receipts and payments

• To be able to prepare and analyse the internal control

procedure for business, debtors & creditors, purchase & sales.

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 Introduction
Control is a basic human requirement and it has existed
throughout the ages in different facets of human activity.
The formalisation of the concept of internal control in the
sphere of business administration is a comparatively
recent phenomenon.
Human behaviour is such that if it is not under some sort
of regulation or control, it often tends to depart from the
proper path. It needs to be kept under systematic watch
not only for ensuring that the employee does his work,
but also to see that he does it in the manner laid down
for the purpose and handles the material and equipment
with proper care.
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 Meaning of Internal Control
• It refers to various methods and procedures adopted
for control of production, distribution and whole
system (financial and non-financial) of the enterprise.

• According to W.W. Bigg, “Internal control is best

regarded as indicating the whole system of controls,
financial or otherwise, established by the
management in the conduct of business including the
internal check, internal audit and other forms of
control.”
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 Concept of Internal Control
• According to AAS-6, internal control may be defined as ““the plan of
organization and all the methods and procedures adopted by the
management of an entity to assist in achieving management’s
objective of ensuring, as far as practicable, the orderly and efficient
conduct of its business, including adherence to management
policies, the safeguarding of assets, prevention and detection of
fraud and error, the accuracy and completeness of the accounting
records, and the timely preparation of reliable financial information.
The system of internal control extends beyond those matters which
relate directly to the functions of the accounting system. The internal
audit function constitutes a separate component of internal control
with the objective of determining whether other internal controls are
well designed and properly operated.”

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 Objectives of Internal Control
AAS-6 lists the following objectives of internal control in relation to an
accounting systems :
(a) transactions are executed in accordance with managements
general or specific authorization;
(b) all transactions are promptly recorded in the correct amount in the
appropriate accounts and in the accounting period in which
executed so as to permit preparation of financial information within a
framework of recognized accounting policies and practices and
relevant statutory requirements, if any, and to maintain
accountability for assets;
(c) assets are safeguarded from unauthorised access, use or
disposition; and
(d) the recorded assets are compared with the existing assets at
reasonable intervals and appropriate action is taken with regard to
any differences.
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The internal control environment
may be affected by
(a) Organisational structure : The organisational structure
of an entity serves as a framework as practicable, to
preclude an individual from overriding the control system
and should provide for the segregation of incompatible
functions. Functions are incompatible if their combination
may permit the commitment and concealment of fraud or
error. Functions that typically are segregated are access
to assets, authorisation, execution of transactions, and
record keeping.

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(b) Management supervision : Management is
responsible for devising and maintaining the
system of internal control. In carrying out its
supervisory responsibility, management should
review the adequacy of internal control on a
regular basis to ensure that all significant
controls are operating effectively

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c) Personnel : The proper functioning of any system
depends on the competence and honesty of those
operating it. The qualifications, selection and training as
well as the personal characteristics of the personnel
involved are important features in establishing and
maintaining a system of internal control.

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 System of Internal Control
It should comprise among other the following;
(i) the proper allocation of functional responsibilities within the
organisation;
(ii) proper operating and accounting procedures to ensure the accuracy
and reliability of accounting data, efficiency in operation and
safeguarding of assets;
(iii) quality of personnel commensurate with their responsibilities and
duties; and finally
(iv) the review of the work of one individual by another whereby the
possibility of fraud or error in the absence of collusion is minimised.
• Further, it is clear from the definition that the scope of internal
control can be extended

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 Elements of Internal Control
Financial and other Organisational plans

Competent personnel

Division of work

Separation of operational responsibility from record keeping

Separation of custody of assets from accounting

Authorisation

Managerial supervision and review 11

 Merits and demerits of Internal Control

Merits Demerits
• Identification of • Chances of human
defects error
• Flexibility • Costly
• Savings in time • Consider Anticipated
• Lesser risk of activity only
omission • Rigidity
• Provision for Training • Abuses of
facility responsibility
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 Inherent limitations of Internal
Control
This is because there are some inherent limitations of
internal control, such as :
(a) management’s consideration that a control be cost-
effective;
(b) the fact that most controls do not tend to be directed at
transactions of unusual nature;
(c) the potential for human error;
(d) the possibility of circumvention of controls through
collusion with parties outside the entity or with
employees of entity;

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(e) the possibility that a person responsible for exercising
control could abuse that authority, for example, a
member of management overriding a control;
(f) the possibility that procedures may become inadequate
due to changes in conditions and compliance with
procedures may deteriorate;
(g) manipulations by management with respect to
transactions or estimates and judgements required the
preparation of financial statements

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 Evaluation of Internal Control
• Examination of effectiveness of internal control
system existing in organisation.

• Matters to be considered:
 Whether the basic principles have been properly
followed;
 Whether the procedures which are prescribed have
been properly implemented;
 Whether the changes made in system desired or not.

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 Steps involved in
evaluation of Internal Control
Determine the extent and types of
control

Determine the controls which are

required for job given

Determine which audit procedure

should be expanded or reduced

Make recommendations to client

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 Review of Internal Control
So far as the auditor is concerned, the examination and
evaluation of the internal control system is an
indispensable part of the overall audit programme. The
auditor needs reasonable assurance that the accounting
system is adequate and that all the accounting
information which should be recorded has in fact been
recorded.

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 Continued....
The review of internal controls will enable the auditor to
know:
(i) whether errors and frauds are likely to be located in the
ordinary course of operations of the business;
(ii) whether an adequate internal control system is in use
and operating as planned by the management;
(iii) whether an effective internal auditing department is
operating

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(iv) whether any administrative control has a bearing on his
work (for example, if the control over worker recruitment
and enrolment is weak, there is a likelihood of dummy
names being included in the wages sheet and this is
relevant for the auditor);
(v) whether the controls adequately safeguard the assets;
(vi) how far and how adequately the management is
discharging its function in so far as correct recording of
transactions is concerned;

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(vii) how reliable the reports, records and the certificates to
the management can be;
(viii) the extent and the depth of the examination that he
needs to carry out in the different areas of accounting;
(ix) what would be appropriate audit technique and the
audit procedure in the given circumstances;
(x) what are the areas where control is weak and where it is
excessive; and
(xi) whether some worthwhile suggestions can be given to
improve the control system.

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 Internal Control Checklist
• This is a series of instructions and/or questions which a
member of the auditing staff must follow and/or answer.
When he completes instruction, he initials the space
against the instruction. Answers to the check list
instructions are usually Yes, No or Not Applicable. This is
again an on the job requirement and instructions are
framed having regard to the desirable elements of
control.

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 A few examples of check list
instructions are given hereunder
1. Are tenders called before placing orders?
2. Are the purchases made on the basis of a written order?
3. Is the purchase order form standardised?
4. Are purchase order forms pre-numbered?
5. Are the stock control accounts maintained by persons who have
nothing to do with :
(i) custody of work;
(ii) receipt of stock;
(iii) inspection of stock; and
(iv) purchase of stock?

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 Internal Control Questionnaire
• This is a comprehensive series of questions concerning
internal control. This is the most widely used for
collecting information about the existence, operation and
efficiency of internal control in an organisation.

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• An important advantage of the questionnaire approach is that
oversight or omission of significant internal control review
procedures is less likely to occur with this method. With a proper
questionnaire , all internal control evaluation can be completed at
one time or in sections. The review can more easily be made on an
interim basis. The questionnaire form also provides an orderly
means of disclosing control defects. It is the general practice to
review the internal control system annually and record the review in
detail. In the questionnaire, generally questions are so framed that a
‘Yes’ answer denotes satisfactory position and a ‘No’ answer
suggests weakness. provision is made for an explanation or
further details of ‘No’ answers. In respect of questions not relevant
to the business, ‘Not Applicable’ reply is given.

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• The questionnaire is usually issued to the client and the
client is requested to get it filled by the concerned
executives and employees. If on a perusal of the
answers, inconsistencies or apparent incongruities are
noticed, the matter is further discussed by auditor’s staff
with the client’s employees for a clear picture. The
concerned auditor then prepares a report of deficiencies
and recommendations for improvement.

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 Internal Control Questionnaire
• A comprehensive list of questions, covering every
aspect of client’s system, which helps in assessing
internal controls in operation.

• Characteristics:
 Questions are simply ‘no/yes/not applicable’
 Requires reviewing and updating at regular intervals;
 Should be properly signed and dated;
 Requires attention of senior staff; etc
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 MCQs
• A number of checks and controls exercised in
a business to ensure its efficient working are
known as:
A. Internal Check
B. Interim Check
C. Internal Audit
D. Internal Control

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 MCQs
• A number of checks and controls exercised in
a business to ensure its efficient working are
known as:
A. Internal Check
B. Interim Check
C. Internal Audit
D. Internal Control

Ans. D. Internal Control

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 MCQs
• Errors and frauds already committed within the
company can be discovered under the system of:
A. internal audit, internal check, internal control
B. external check
C. statutory audit
D. interim audit

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 MCQs
• Errors and frauds already committed within the
company can be discovered under the system of:
A. internal audit, internal check, internal control
B. external check
C. statutory audit
D. interim audit

Ans. a) internal audit, internal check, internal

control .
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 MCQs
• The work of one clerk is automatically check
by another clerk is called:
A. internal control
B. internal check
C. internal audit
D. interim audit

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 MCQs
• The work of one clerk is automatically check
by another clerk is called:
A. internal control
B. internal check
C. internal audit
D. interim audit

Ans. B. internal check

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 MCQs
• Internal auditor can be removed by the:
a) Government
b) Shareholders
c) Management
d) Company Law Board

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 MCQs
• Internal auditor can be removed by the:
a) Government
b) Shareholders
c) Management
d) Company Law Board

Ans. c) Management

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 Learning Outcomes
• To analyze the internal control over cash
receipts& payment, debtors and creditor
etc.

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 Cash & Sales Collections
1. Limit the no. of persons who receive cash
2. Establishing means of evidencing cash
receipts- Cash registers
3. Ensuring that amount entered is visible to the
customers
4. Appointment of officers giving responsibility to
check at prescribed intervals
5. Payment should be from bank
6. Investigation of shorts
7. Rotation of duties
8. Collection by salesman should be banked daily.37
 Cash Control

• To control and manage its cash, a company should:

• Account for all cash transactions accurately so that
correct information is available regarding cash flows and
balances.
• Make certain that enough cash is available to pay bills as
they come due.
• Avoid holding too much idle cash because excess cash
could be invested to generate income, such as interest.
• Prevent loss of cash due to theft or fraud.

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 Internal control over cash
receipts
• Prepare a record of all cash receipts as soon as cash is received.
Most thefts of cash occur before a record is made of the receipt.
Once a record is made, it is easier to trace a theft.
• Deposit all cash receipts intact as soon as feasible, preferably on
the day they are received or on the next business day. Undeposited
cash is more susceptible to misappropriation.
• Arrange duties so that the employee who handles cash receipts
does not record the receipts in the accounting records. This control
feature follows the general principle of segregation of duties given
earlier in the chapter, as does the next principle.
• Arrange duties so that the employee who receives the cash does
not disburse the cash. This control measure is possible in all but the
smallest companies.

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 Payment into bank
1. Cash & cheques should be deposited in
banks immediately
2. Pay in slips(bank) should be kept by the
person other than the one who collects
cash
3. Banking should be made with security
4. Comparison of Pay in slips with collection
records.

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 Cheque Payment
1. Control over custody and issue of unused chequebook
2. Appointment of official for the preparation of cheques
3. Presentation of supporting documents such as orders,
invoice before cheque can be prepared
4. All document should be stamped “Paid by cheque No.
and date”.
5. No bearer cheque to be issued except payment of
wages
6. All cheques to be crossed
7. Signing on blank cheques to be prohibited.
8. Seperation of duties from Custody of cheques & Issue
of cheque payments
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 Purchase & Trade Creditors
1. Reqiuisition of goods and services should be done by
specified person.
2. Purchase order form should be prenumbered and kept
in safe custody
3. All goods received should be recorded in special book.
4. All goods received should be physically checked.
5. Unfullfilled orders should be investigated at intervals
6. Total enteries should be regularly checked
7. Ledger accounts should be regularly compared with
supplier’s statements of accounts.

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 Sale & Trade Debtors
1. Incoming order of goods and services should be done
by specified person.
2. Sale invoice form should be prenumbered and kept in
safe custody
3. All goods sent for sale should be recorded in special
book.
4. Customer claims should be recorded and investigated.
5. Accounting of sales and debtors should be done
separately.
6. Total entries should be regularly checked
7. Ledger accounts should be regularly compared with
debtor’s statements of accounts.
8. Bad debts to be written off only after investigation and
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acknowledged by senior official.
 Internal Control in Cash
Payments
• Make all disbursements by check or from petty cash. Obtain proper
approval for all disbursements and create a permanent record of
each disbursement. Many retail stores make refunds for returned
merchandise from the cash register. When this practice is followed,
clerks should have refund tickets approved by a supervisor before
refunding cash.
• Require all checks to be serially numbered and limit access to
checks to employees authorized to write checks.
• Require two signatures on each check over a material amount so
that one person cannot withdraw funds from the bank account.
• Arrange duties so that the employee who authorizes payment of a
bill does not sign checks. Otherwise, the checks could be written to
friends in payment of fictitious invoices.
• •enquire approved documents to support all checks issued.
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• Instruct the employee authorizing cash disbursements to make
certain that payment is for a legitimate purpose is made out for the
exact amount and to the proper party.
• Stamp the supporting documents paid when liabilities are paid and
indicate the date and number of the check issued. These
procedures lessen the chance of paying the same debt more than
once.
• Arrange duties so that those employees who sign checks neither
have access to cancelled checks nor prepare the bank
reconciliation. This policy makes it more difficult for an employee to
conceal a theft.
• Have an employee who has no other cash duties prepare the bank
reconciliation each month, so that errors and shortages can be
discovered quickly.
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 Internal Control & Financial
Control
Internal control, so far as financial and accounting
aspects are concerned, aims at:
(i) Providing the flow of work through various stages.
(ii) Breaking the chain of the work in a manner so that no
single person can handle a transaction from the
beginning to the end.
(iii) Segregation of accounting and custodial functions.
(iv) Securing proper documentation at each stage.
(v) Specifying authority to enter into the various
transactions and for every action connected therewith.

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(vi) Recording the transactions in the books of account
correctly.
(vii) Safeguarding of assets.
(viii) Making errors and frauds difficult.
(ix) Fixing responsibility for the work and the responsibility
for deviations.
(x) Building up a system to locate the deviations and
departures from the prescribed procedures and to detect
frauds and errors automatically without much loss of time
(xi) Elimination of conflicting responsibilities.
(xii) Evolving standardised records.
(xiii) Providing account charts and the accounting manual.
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(xiv) Preparation of periodical accounting and financial
report.
(xv) Making the work simpler as far as practicable.
(xvi) Minimising loss and wastage.
(xvii) Encouraging employees to do willing and good work.
(xviii) Discouraging employees from non-compliance with
the prescribed procedures.
(xix) Appraisal of the operations

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 Internal control & management
It is also important to bear in mind that the system installed
needs review by the management to ascertain:
(i) whether the prescribed management policies are being
properly interpreted by the employees and are faithfully
implemented;
(ii) whether the prescribed procedures need a revision
because of changed circumstances or whether they
have become obsolete or cumbersome; and
(iii) whether effective corrective measures are taken
promptly when the system appears to breakdown.

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 COMMUNICATION OF WEAKNESSES IN
INTERNAL CONTROL

As a result of obtaining an understanding of the

accounting and internal control systems and tests of
control, the auditor may become aware of weaknesses in
the systems. The auditor should make management
aware, as soon as practical and at an appropriate level
of responsibility, of material weaknesses in the design or
operation of the accounting and internal control systems,
which have come to the auditor's attention. The
communication to management of material weaknesses
would ordinarily be in writing..

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However, if the auditor judges that oral communication is
appropriate, such communication would be documented
in the audit working papers. It is important to indicate in
the communication that only weaknesses which have
come to the auditor's attention as a result of the audit
have been reported and that the examination has not
been designed to determine the adequacy of internal
control for management purposes.

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 MCQ

________________ is a complete and exhausted

description of the system as found in operation by the
auditors.
a) Check List
b) Flow Chart
c) Narrative Records
d) Internal Control Questionnaire

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 MCQ

________________ is a complete and exhausted

description of the system as found in operation by the
auditors.
a) Check List
b) Flow Chart
c) Narrative Records
d) Internal Control Questionnaire

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 MCQ

________________is a series of instruction and

questions which the auditor should follow and answer.
a) Narrative Records
b) Check List
c) Internal Control Questionnaire
d) Flow Chart

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 MCQ

________________is a series of instruction and

questions which the auditor should follow and answer.
a) Narrative Records
b) Check List
c) Internal Control Questionnaire
d) Flow Chart

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 MCQ

_______________is a graphic presentation of each part

of the entity’s internal controls system.
a) Narrative Records
b) Check List
c) Internal Control Questionnaire
d) Flow Chart

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 MCQ

_______________is a graphic presentation of each part

of the entity’s internal controls system.
a) Narrative Records
b) Check List
c) Internal Control Questionnaire
d) Flow Chart

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 MCQ

Which of the following in inherent limitation of internal

controls
a) Role of human judgement
b) Ineffective operation of control
c) Collusion among employees
d) All of these

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 MCQ

Which of the following in inherent limitation of internal

controls
a) Role of human judgement
b) Ineffective operation of control
c) Collusion among employees
d) All of these

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