CHAPTER 21
FINANCIAL SYSTEM AND INTERNAL
CONTROL
SYSTEM OBJECTIVES
Accounting system activities:
System refers to the structured process, procedure, and software used by the business.
• Initiation (e.g. Manually or by programmed procedures);
• Recording (e.g. Identify, capture and record valid transactions and relevant information
on a timely basis, including information for disclosure);
• Processing (e.g. Edit, validate, calculate, measure, summarise, reconcile and classify);
• Reporting (e.g. Preparation of financial and other statements so that the transactions,
disclosures and other information are correctly presented); and
• Maintaining accountability (for the related assets, liabilities and equity)\
PURCHASING
Objectives:
The system's main objective is to record purchases and pay suppliers the money
they are owed for items purchased from them.
SALES INVOICING
Objectives:
The main objective of a sales invoicing system should be to send invoices to
customers for items they have purchased and record payments received.
PAYROLL
Objectives:
The main objective of a payroll system should be to pay employees their wages
or salaries in full and on time, having made any required deductions first, such as
for income tax
CREDIT CONTROL
Objectives:
The main objective of a credit control system is to allow customers time to pay
for what they have purchased – to give them credit. An organisation may achieve
higher sales revenue by providing customers credit.
Credit control procedures:
I. Decide credit policy
II. Decide credit term
III. Check for credit while making a sale
IV. Check for payment and pursue late pays.
CASH AND WORKING CAPITAL
Objectives:
The cash and working capital management system is usually a responsibility of
the treasury section in large business organisations.
The main objective is to ensure that the business organisation has enough cash to
meet its operational requirements and can make payments for what it owes in full
and on time.
PROCEDURES:
• Prepare cash budget
• Monitor bank position
• Monitor inventory and receivables
• Manage payment to suppliers
WEAKNESS
Weakness Description
The financial system A significant cause of errors in
accounting systems is unintentional
has weaknesses: Human error
mistakes by people. People can forget to
do something, do something incorrectly,
or misunderstand what they have been
asked to do.
A deliberate criminal act by an employee
Fraud to obtain financial benefit from an
employer is called fraud.
Computer systems may fail, for example,
Computer system failure due to hardware failure or a cyber-
attack.
There may be unsatisfactory or no
procedures for dealing with unusual
Poor procedures
circumstances, such as a partial
payment from a customer.
An accounting system may be inefficient.
For example, an accounting system with
manually-kept books will be less efficient
Inefficient systems
at dealing with a large volume of
transactions than a computerised
system.
INTERNAL CONTROL
Definition:
Internal control - system, policies, and procedures implemented to prevent fraud
and error which ensures.
1. reliability of financial reporting;
2. effectiveness and efficiency of operations; and
3. compliance with applicable laws and regulations
INTERNAL CHECKS
Definition:
An internal check is a control activity (segregation of duties). It is a procedure or
series of procedures that:
• ensures that the same individual does not carry out a procedure from start to
finish so that
• the work of each individual is subject to an independent check by another
individual.
CONSEQUENCES
If internal financial controls are not adequate, the following might happen:
o Undetected fraud may occur.
o Accounting records might contain errors or omissions
o Employees are not paid the correct amount they are owed in wages or salary,
affecting morale.
o The business may run out of cash, increasing default risk.
o It will be impossible to prepare reliable financial statements for presenting to
management and shareholders.
LIMITATIONS
Limitation Description
Internal control can provide reasonable assurance about the
reliability of financial reporting, the efficiency and
Reasonable but not absolute assurance effectiveness of operations and compliance with laws and
regulations, but it cannot provide absolute assurance.
Control weaknesses and failures may occur.
An internal check may provide for one person’s work to act
as a check on the accuracy – and honesty – of someone
Collusion else’s work. But the two individuals may collude together
to commit a dishonest act. The internal check will be
ineffective if this happens.
Some controls may be poorly designed and, as a result,
Weak or ineffective controls
fail to fulfil their intended control purpose.
Controls may be ineffective because they are not used
correctly, perhaps because an individual does not
Operational errors with controls
understand what the control is for or fails to take action when
a warning sign is given.
Controls may be ineffective because a manager chooses to
Overriding controls override the control – ignore it – and do something that
the control is intended to prevent.
Controls may not be possible because the organisation is
too small.
For example, internal checks can be created by segregating
Problems with small size tasks or duties so that the work of one person can act as a
check on the work of another.
This would be impractical or too expensive for a small
business with only a few employees.
RESPOSNIBILITY
Board of Directors- The board has ultimate responsibility for the effectiveness of a company’s
internal controls.
Management- If there are weaknesses in the internal control system, management should identify
them and try to correct them.
Individuals- Individuals are expected to follow the required procedures for their work.
INTERNAL vs EXTERNAL AUDITOR
Auditor Role
Internal auditors are not
responsible for the effectiveness of
internal controls.
They can investigate procedures
Internal auditor and check records and advise the
board of directors, the audit
committee and management about
weaknesses and control failures
they find.
External auditors are not
responsible for the effectiveness of
internal controls.
They may identify weaknesses or
failures in internal financial controls
External auditor
that they come across during their
audit work.
If they do, they should inform
management, the board of
directors, or the audit committee.
TYPES OF INTERNAL CONTROL:
Purpose Description Example
Using a safe or strong box
Prevent an error or failure to hold valuable items
Prevent
from happening. prevent the items from
being stolen or lost.
A performance report
compares actual results in a
recent period with what
Detect an error when it was planned or expected. It
Detect happens or after it has feeds information about the
happened. difference (or variance) to
management for
investigation and control
action.
A sales invoicing system
may detect a delinquent
Correct a failure or error
receivable and produce
Correct that has occurred and has
automatically send a
been detected.
payment reminder letter to
the customer.
Advantages of External Audit:
Solves Disputes in Management: External audits can provide an independent and
unbiased assessment of financial records, resolving disputes or disagreements within
management regarding financial matters.
Trustworthy Proof for Financiers: External audit reports serve as credible and
reliable evidence of an organization's financial health and performance, enhancing
trust and confidence among investors, creditors, and other stakeholders.
Provides Constructive Feedback: External auditors may offer valuable insights and
recommendations for improving internal controls, operational efficiency, and
financial reporting processes based on their observations during the audit.
Disadvantages of External Audit:
Expensive Service - Audit Fees: External audits can be costly, particularly for smaller
organizations or those with complex financial structures. Audit fees may include charges for
professional services, time spent by auditors, and expenses associated with conducting the
audit.
Needs Careful Planning, Might Cause Disruption: External audits require careful planning
and coordination with the organization's management and staff. The audit process may disrupt
normal business operations and require the allocation of significant time and resources to
facilitate auditor access to financial records and personnel.
