Chapter 16: Internal

Control Affecting Assets

EXPECTED
LEARNING
OUTCOME:

Describe the internal control over the major components of assets of a business enterprise
namely
a) Cash
b) Financial Investments
c) Receivables: Accounts and Notes and related revenue accounts
d) Inventories and related Cost of Goods sold
e) Property, Plant and Equipment
 Understand the potential misstatements (due to fraud and errors) of the asset accounts and
how weakness in internal control increases the risks of misstatements.
CASH
Most of the processes relating to cash handling are the responsibility of the finance
department, under the direction of the “treasurer”
These processes include:
Handling and depositing cash receipts,
signing checks; investing idle cash, and maintaining custody of
cash,
marketable securities,
and other negotiable assets.
• Ideally, the functions of the finance department and the accounting department
should be integrated in a manner that provides assurance that:
1. All cash that should have been made for authorized purposes was in fact received, recorded
accurately and deposited promptly.
2. Cash disbursement has been , made for authorized purposes only and have been properly
recorded.
3. Cash balances are maintained at adequate, but not excessive, levels by forecasting expected
cash receipts and payments related to normal operations. The need for obtaining loans for
investing excess cash is thus made known on a timely basis.
Internal control over cash;

 Do not permit any one employee to handle a transaction from beginning to end.

 Separate cash handling from record keeping.

 Centralize receiving of cash to the extent practical.

 Record cash receipts on a timely basis.

 Encourage customers to obtain receipts and observe cash register totals.

Continuation…

 Deposit cash receipts daily.

 Make all disbursements by check or electronic funds transfer with the exception of
small expenditures from petty cash.

 Have monthly bank reconciliation prepared by employees not responsible for the
issuance of checks or custody of cash. The completed reconciliation should be
reviewed promptly by an appropriate official.

 Monitor cash receipts and disbursements by comparing recorded amounts to

forecasted amounts and investigating variances from forecasted amounts.
Potential Misstatements – Cash Receipts

• Recording fictitious cash receipts

• Failure to record receipts from cash sales
• Failure to record cash from collection at accounts receivable
• Early (late) recognition of cash receipts – “cut off problem”
Potential Misstatements – Cash Disbursements

• Inaccurate recording of a purchase of disbursements

• Duplicate recording and payment of purchases
• Unrecorded disbursements
FINANCIAL INVESTMENTS
Financial investments are assets that can be traded, or they can also
be seen as packages of capital that may be traded.
Marketable stocks and bonds are the most important group of
financial investments.
Derivatives are financial instruments that “derive” their value from
other financial instruments, underlying assets, or indexes.
Example: A simple derivative would involve a commitment by a
company to purchase a commodity at a certain price at some point in
the future
• The major elements of adequate internal control over financial
investments include the following:
1. Formal investment policies that limit the nature of investments in securities
and other financial instruments.
2. An investment committee of the board of directors that authorizes and
reviews financial instruments activities for compliance with investment
policies.
3. Separation of duties between the executive authorizing purchases and sales
of securities and derivative instruments, the custodian of the securities and
the person maintaining the records of investments.
Continuation…

4. Complete detailed records of all securities and derivative

instruments owned and related provisions and terms.
5. Registration of securities in the name of the company.
6. Periodic physical inspection of securities on hand by an internal
auditor or an official having no responsibility for the authorization,
custody, or record keeping of investments.
7. Determination of appropriate accounting for complex financial
instruments by competent personnel.
In many concerns, segregation of the functions of custody and record
keeping is achieved by the use of an independent safekeeping agent.

If no independent agent, it should be kept in a bank safe-deposit box

under the joint control or two or more of the company’s official.

Complete detailed records of all securities and derivative instruments

owned are essential to satisfactory control.
 Potential Misstatements – Financial Investments

• Misstatements of recorded value of investments

• Unauthorized investment transactions
• Incomplete recording of investments
RECEIVABLES
Accounts receivable include not only claims against customers arising
from sale of goods or services, but also a variety of miscellaneous
claims such as loans to officers or employees, loans to subsidiaries,
claims against various other films, claims for tax refunds and
advantages to suppliers.

Notes receivable are written promises to pay certain amounts at future

dates.
 Control environment
Control environment is very important to effective internal control over
revenue and receivables.
An independent audit committee of the board of directors that monitors
management’s judgments about revenue recognition principles and
estimates, as well as well as an effective internal audit function.
The control environment is greatly influenced by the extent to which
individuals recognize that they be held accountable.
 Receivables
To understand the internal control over accounts receivable and
revenue, one must consider the various components, including
• Control environment
• Risk assessment
• Monitoring
• The (accounting) information and communication system
• Control activities
 Potential Misstatements – Revenue/Receivables

• Recording unearned revenue

• Early (late) recognition of revenue – “cutoff error”
• Recording revenue when significant services still must be
performed by seller
• Overestimation of the amount of revenue earned
Internal control over Notes Receivable
As previously stated, a basic characteristic of effective control consists of
the subdivision of duties. As applied to notes receivable, this principle
requires that:
1. The custodian of notes receivable not have access to cash or to general
accounting records.
2. The acceptance and renewal of notes be authorized in writing by responsible
official who does not have a custody of the notes.
3. The write-off of defaulted notes be approved in writing by responsible officials
and effective procedures adopted for subsequent follow-up of such defaulted
notes
INVENTORIES AND COST OF
GOODS SOLD
 Internal control over inventories and
COGS
The controls that assure the fair valuation of investors are found im
the purchases (or acquisition) cycle.
These controls include:
• Procedures for selecting vendors
• Ordering merchandise or materials
• Inspecting goods received
• Recording the liability to the vendor
• Authorizing and making cash disbursements
• In a manufacturing business, the valuation of inventories also is affected
by the production cycle, in which manufacturing costs are assigned to
inventories, and the cost of inventories is then transferred to the cost of
goods sold.
 INVENTORIES AND COST OF GOODS SOLD

The term inventories is used in this chapter to include:

1. Goods on hand ready for sale, whether the merchandise of a trading concern or the finished
goods of a manufacturer
2. Goods in the process of production; and
3. Goods to be consumed directly or indirectly in production, such as raw materials,
purchased parts, and supplies
 Potential Misstatements – Inventory/COGS

• Misstatement of inventory costs

• Misstatement of inventory quantities
• Early (late) recognition purchases – “cutoff problems”
PROPERTY PLANT AND
EQUIPMENT
 PPE
The term property, plant and equipment includes all tangible assets with a service life
of more than one year that are used in the operation of the business and are not
acquired for the purpose of resale. Three major subgroups of such assets are generally
recognized:
 Land, such as property used in the operation of the business, has the significant characteristic of
not being subject to depreciation.
 Building machinery, equipment and land improvements, such as fences and parking lots, have
limited service lives and are subject to depreciation
 Natural resources (wasting assets), such as oil wells, coal mines, and tracts of timber, are
subject to depletion as the natural resources are extracted or removed
 Internal control over PPE
The amounts invested in plant and equipment represents a large portion of the
total assets of many industrial concerns.
Maintenance, rearrangement and depreciation of these assets are major expenses
in the income statement.
The total expenditures for the assets and related expenses make strong internal
control essential to the preparation of reliable financial statements.
The losses that inevitably arise from uncontrolled methods of acquiring,
maintaining and retiring plant and equipment are often greater than the losses
from fraud in cash handling.
In large enterprises, the auditors may expect to find an annual plant budget used
to forecast and control acquisitions and retirements of plant and equipment.

Many small companies also forecast expenditures for plant assets

A detailed knowledge of the kinds, qualities and condition of existing equipment

is an essential basis for intelligent forecasting of the need for replacements and
additions to the plant.
Other key controls applicable to plant and equipment are as follows:

1. A subsidiary ledger consisting of a separate record for each unit property

2. A system of authorization requiring advance executive approval of all plant and equipment
acquisitions, whether by purchase, lease or construction.

3. A reporting procedure assuring prompt disclosure and analysis of variances between authorized
expenditures and actual costs.

4. An authoritative written statement of company policy distinguishing between capital

expenditures and revenue expenditures.
5. A policy requiring all purchases of plant and equipment to be handled though the
purchasing department and subjected to a standard routine for receiving, inspection
and payment.

6. Periodical physical inventories designed to verify the existence, location and

condition of all property listed in the accounts and to disclose the existence of any
unrecorded units.

7. A system of retirement procedures, including serially numbered retirement

work orders, stating reasons and bearing appropriate approvals.
Potential Misstatements – Investment in PPE

• Misstatements of acquisition of property, plant and equipment

• Failure to record retirements of property, plant and equipment
• Improper reporting of unusual transactions
ARE YOU READY FOR THE QUIZ?