’ re nag ici Internal Control As the size of the operations of an entity increases and nature of activities become com> it becomes difficult for the manager of the entity to control the operations of the entity by his ¢ and close supervision. Control under his nose is impossible for every activity and even if pos: it would prove to be very costly in terms of time and efficiency. What the management in s circumstance is interested is to devise a system which in its efficient operation provides desi control-effects. An efficient system of control is established by the management as a matter convenience and effectiveness. Internal Control—Meaning, Importance Spicer & Peglar, a famous authority on auditing literature, defines the system of inter control as “Internal control is best regarded as the whole system of controls, financial and other: established by the management in the conduct of a business including internal check, internal au and other forms of control”. This definition implies the following (a) The internal control is a system of controls. () Controls are established over financial and non financial areas (©) The mechanism of controls may manifest itself in the forms of internal check or intern: audit or other forms. The Statement on Auditing Practices (SAP-6) of the Institute of Chartered Accountants India describes internal control as “the plan of organisation and all the methods and procedure adopted by the management of an entity to assist in achieving management's objective of ensurin as far as possible, the orderly and efficient conduct of its business, including adherence management policies, the safeguarding of assets, prevention and detection of fraud and error, the accuracy and completeness of the accounting records and timely preparation of reliable financie. information. The system of internal control extends beyond those matters which relate to the functions of accounting system”, This definition throws light on the complete realm of internal control. The intemal control, according to this definition, implies the following: Internal control is a prescription and practice of a system by management. The system encompasses plan, methods and procedures prescribed for and practised by the internal constituents of an entity. ‘The aim for prescription and practice of such a system is to ensure control over accounting and other administrative areas in order to bring forth efficiency and orderliness. 112— internal Control 113 internal Control—Accounting, Administrative Controls We have seen that the internal control areas spread over accounting and non-accounting spheres. Internal control, as it applied to accounting system, implies control over accounting system with the aim of achieving the following objectives: (a) Efficient and orderly conduct of accounting transactions (b) Safeguarding the assets in adherence to management policy (c) Prevention of error, detection of error (d) Prevention of fraud, detection of fraud (e) Ensuring accuracy, completeness, reliability and timely preparation of accounting data. On the other hand administrative controls seek to achieve the aim of management in efficient and orderly conduct of transactions, in non-accounting areas. It seeks to ensure the adherence to management policy in various areas of business operations. For example in a manufacturing system of a business enterprise, the internal control may be established to ensure the adherence of management policy as to quality (quality control), safeguarding assets (control over wastages, ABC control over raw materials) prevention of errors (monitoring production methods, maintenance programme for machines), prevention of frauds (security system), timely supply of reliable management information (MIS). An auditor is mainly concerned with good accounting control of internal control system. If good internal control system exists in accounting system, an auditor can put greater reliance on the financial data generated in the system with test checking of select items. If the accounting control is not strong, the auditor may have to resort to detailed checking of transactions, events, and practices in the accounting system. With regard to administrative controls, the auditor may evaluate those part of administrative controls as may have bearing on the financial information of the entity. For example before certifying the valuation of stocks, the auditor may refer to the reports of consumption. patterns prepared by manufacturing segment to administration, if the auditor feels material discrepancy in physical quantity of stocks. On the other hand, he may not be concerned no more than a matter of general interest with the quality report of chemical A used in operation X. Internal Check ‘We have seen that internal check is one of the modes of executing internal control. As applied to accounting system internal check is a method of organising the accounts system of a business concern or.a factory where the duties of different clerks are arranged in such a way that the work of one person is automatically checked by another and thus the possibility of fraud, or error, or irregularity is minimised unless there is a collusion between the clerks, e.g., the receipt of cash is enteréd by the cashier on the debit side of the cash book; this entry is carried to the ledger by another clerk; the statement of account relating to this transaction is sent to the customer by a third clerk and so on. Thus, we see that the same transaction has passed through three different hands, and the work of one is checked automatically by the other. It is a kind of division of labour. This minimises the possibilities of frauds and errors unless all the three join hands in defrauding their employer. Again if an error or fraud has been committed, it will be detected very soon by another clerk while the transaction is being automatically checked. LR. Dicksee defines Internal Check as “such an arrangement of book-keeping routine that errors and frauds are likely to be prevented or discovered by the very operation of the book- keeping itself.” FRM. de Paula defines it as “Internal Check means practically a continuous internal audit carried on by the staff itself, by means of which the work of each individual is independently checked by other members of the staff.”114 : A Hand Book of Practical Auditing Professor Arnold W. Johnson, in his book, Auditing Principles and Case Problems, defines internal control system as one wherein the accounting work of the employee is complemented and verified by the work of another employee-both employees working independently and without duplication of each other’s work. “Internal Check—a system under which the accounting methods and details of an establishment are so laid out that the accounts and procedures are not under the absolute and independent control of any one person—that, on the contrary, the work of one employee is complementary to that of another— and that a continuous audit of the business is made by employees.” Special Committee on Terminology, American Institute of Accountants, 1949. Under this system, the clerk incharge of a book of prime entry should not have access to the ledger and vice versa. Self-balancing ledger system, time-recording clocks regarding wages or automatic tills for recording cash receipts, are some of the devices by which the commission of fraud may be prevented. No one is allowed to deal with one book throughout the year. Therefore the work of the members of the staff should be changed from time to time and if it is found expedient they should be encouraged to take leave. In such a case it will be easy to detect an error or fraud committed by the absentee member of the staff. Under this system wage sheets are prepared and chacked from different records by different clerks. In case of cash sales, the salesman does not receive the money from the customer, nor does he deliver the goods to him. Cash is received by the cashier; the goods are delivered by the gate-keeper, and all the three, viz., the salesman, the cashier and the gate-keeper, send their own statements regarding the sales, receipt of cash and the delivery of goods, in the evening to the General Manager who compares these statements and if he finds any discrepancy, he makes an investigation. Under such a system, unless all the three’join hands, there is no possibility of fraud. Similarly when the goods are purchased on credit, entries are made regarding the purchase by the gate-keeper, who records the name of the supplier, the quantity of goods and the date on which they were received; another entry is made by the keeper of the purchases book, the godown- keeper, etc. Thus, the same entry is recorded by different clerks and the possibility of fraud or mistake is reduced to the minimum. The applications of some of the automatic devices, e.g., cash registers, time recording clocks, book-keeping and calculating machines, etc., prevent the commission errors and frauds. The clerks should be transferred from one department or job to another department or job from time to time without any prior notice. Members of the staff should be encouraged to go on leave as in case frauds, if any, committed by the clerk may come to light. From the above definitions and discussion, it would be apparent to the readers that the work is sub-divided amongst many persons and hence the internal check system can be usefully employed by big concerns. In a small concern, this system is not practicable as a clerk has to handle assets as well as the records. (The aim of the application of internal check is the prevention and alternatively the early detection of frauds, errors, and misappropriation. But it must not be presumed that where the internal check is in operation, there cannot be an error or a fraud. The internal check system minimises or makes difficult the chances of committing frauds, thefts or irregularities.) The advantage of the existence of good and efficient internal check is that in that case the auditor can rely upon the accuracy of the accounts. Even though he finds a very efficient internal check system in operation, he should not be negligent but must be alert. He should apply test checks to a few items selected at random/ e.g., in case of payment of wages, he should compare the attendance of the workers with the gate-Keeper's record, foreman's record, the wages sheet and the cash book. On the other hand if he finds that the internal check system in the business is not_ 7 internal Control 115 satisfactory he should be very careful and test checks should be extensive and thorough and he ould mention that fact in his report.) ‘ Evaluative Criteria for Good Internal Check A good internal check system must provide in-built checks and balances while the operations are being performed. To achieve this end, the following control mechanism may be introduced: (a) Division of Work: No one should be allowed to have right to perform the work from origin to end. For example, a transaction of sale may have to be split into display of article by a staff, the preparation of invoice by another, the receipt of cash against the invoice by a third clerk, the delivery of article against the proof of receipted invoice by another clurk, checking of outward movement of article against delivery order by a clerk and so on. In big business houses, such specialised tasks increase the speed of work and automatically introduce internal check. (8) Job Rotation : No individual clerk should be allowed to occupy a particular area of operation for long. Familiarity with and exclusiveness in a position offers a person greater flexibility to attempt manipulation with the system. (c) Authority Levels: There must be clear cut authority levels for according sanctions to various transactions. Commensurate to the authority vested, responsibility must be extracted. Existence of authority levels result in review of operations of subordinates. (d) Separation of Custody & Recording : There needs to be effective control by way of separation that the persons handling an asset cannot make entries for the transactions without any counter check. For example in a bank the payments effected by cashier are entered in his rough cash chits. Simultaneously the officer authorising payments maintain a scroll of payments authorised. (€) Accounting Controls : In order to ensure internal check with regard to recording of transactions in accounting records various cross checks must be introduced to ensure that the accounting records reflect reliable information. Use of control accounts, self-balancing system, preparation of reconciliation statements etc add checks to the system Internal Checks for various Transactions general internal checks that must operate in respect of various types of transactions. Specifically, these checks may vary to suit the peculiar circumstances of actual case. The general checks {n respect of cash transactions-receipt, payment and trading transactions- purchases, sales, stock ke&ping etc are detailed in the chapter vouching of cash transactions, (chapter v) and vouching of trading transactions (chapter vi). The readers may refer to the relevant sections in the chapters. Internal Audit As discussed in definition of internal control, the control is exercised in the forma of internal check and internal audit. Internal check is concerned with so devising the form and flow of operations of an entity that automatic checks are carried out as the transactions occur, On the other hand, internal audit is a critical appraisal of functioning of various operations of an enterprise including the functioning of the system of internal check. Exceptions from normal functioning of internal check system are exposed in internal audit. Accuracy, completeness, reliability and timeliness of accounting information are tested and reported for remedial action. Non-accounting areas viz. operational side of enterprise are critically studied, analysed and weakness of the system or practice - viz., inefficiency, wastage, frauds etc - are brought to the notice of the management. Suggestions for increasing the effectiveness of the system, for improving the productivity and profitability of business practices are offered. That part of internal audit dealing with operational side of the entity to improve efficiency is termed as operational audit. That part of internal audit aiming at improvingao ae — 116 A Hand Book of Practical Aust the effectiveness.of accounting and administrative and other operational systems.are called sy audit. ‘Internal audit is the independent appraisal of activity within an organisation for the se of accounting, financial and other business practices as a protective and constructive ar= management. It is a type a which functions by measuring and evaluating the effective of other types of control.”(Professor Walter B. Meigs of America says: “....intenal auditing com of a continuous, critical review of financial and operating activities by a staff of auditors functio= as full-time salaried employees.” YInternal audit is an inde appraisal activity with organisation for the review of accounting, financial and other operations as a basis for servi the management”, definition by the Institute of Internal Auditors, Inc., New York in the publi: statement Responsibilities of Internal Auditors, under the heading “Nature of Internal Audit”. Inte audit implies an audit of the accounts by the employees of the business. The work is done > separate set of staff who may or may not have professional audit qualifications. The function o: internal auditor is practically the same as that of an auditor. In addition to that an internal audit ' to see that there is no wastage and the business is carried on efficiently, e.g., when purchas. furniture whether tenders were invited; when waste materials were sold, whether they were sold auction or by inviting tenders and so on. Again if an internal auditor finds that as a result of inefficiency of the management, the concern has suffered a loss, it is his duty to report that fact. = has to report to the management whether the policy and plans of activities prescribed by them ha been implemented; whether the internal controls and checks established were adequate; whet the actual results obtained were varying from the estimates,etc., to enable the management to achic the objective of the company in the planned manner. It is a kind of continuous audit but conduc by the staff of the concern. In the case of large concerns like banking or insurance companies local bodies, they have a separate Internal Audit Department. If such a Department is worki= independently and efficiently the auditor may depend upon the checking undertaken by such Department. Internal Audit and Statutory Audit ‘We have seen the meaning of internal audit in the foregoing paragraphs. Let us now see whs is meant by Statutory Audit. When an audit is conducted under the statute, it is called Statuto Audit, e.g. the audit of joint-stock companies. Distinction between Internal Audit and Statutory Audit Let us see the points of distinction between the two audits: 1. Appointments. Internal auditor is appointed by the management while the statutory audit is appointed by the shareholders except in certain cases when he is appointed by directors of the company or the Government. Appointment of internal auditor is optional while that of the statutory auditor is obligaton Again appointment in the former case is according to the decision of the manageme= while that of the statutory auditor is according to the Companies Act. 2. Qualifications. Internal auditor need not posses the qualifications as are laid down uné= Section 226 of the Companies Act while a statutory auditor must have those qualifications 3. Status. Internal auditor is an employee of the company while the statutory auditor is = independent person. 4. Conduct of Audit. An internal audit is a kind of continuous audit while a statutory aud is generally conducted after the preparation of the final accounts. 5. Scope df Work.The scope of the work by the internal auditor is determined by th: management while the scope of the work by and the responsibilities of the statuton auditor are determined by law. a : . - 3 : a 4 1 a 4- internal Control 117 6. Objective. An internal auditor has the primary duty to find out whether any error or fraud has been committed while the statutory auditor has to report whether the balance sheet and the profit and loss account of a company have been drawn up in conformity with law and whether they show true and fair view of the state of affairs of the company. Detection of errors and frauds are incidental duties of a statutory auditor. 7. Determination of Duty. The scope and duties of an internal auditor can be reduced while it is not so in the case of a statutory auditor. 8. Internal auditor has to. make. suggestions to the management as to how to run the business efficiently and to avoid wastages but a statutory auditor need not do so unless he is specifically asked. 9, Internal auditor has to check. all the transactions while the statutory auditor may apply test checks, 10. Report. Internal auditor has not to submit any report to the shareholders while a statutory auditor has to do so. 11. Application of Chartered Accountants Act. Internal auditor cannot be prosecuted for professional misconduct unless he is a Chartered Accountant while a statutory auditor can be prosecuted. 12. Removal. Internal auditor can be removed by the management or the directors while a statutory auditor can be removed only by the shareholders and not by the management or the directors. 13. The internal auditor acts as a watch-dog for the directors while the statutory auditor has to act as a watch-dog for the shareholders. 14. Internal audit is carried out for the satisfaction of the management of the concern while the statutory audit is carried out for the satisfaction of the shareholders and third parties for the financial data. 15. Remuneration. Remuneration of the internal auditor are fixed by the management while for the statutory auditor they are fixed by the shareholders. 16. Attendance at Meetings. Internal auditor has no right to attend a meeting of the shareholders while a statutory auditor has such a right. 17. The activities of the internal auditor are continuous while those of the statutory auditor are periodic, usually for a year. The internal audit is not made compulsory under Companies Act. However it is desirable to have internal audit. Under section 227-4A the company auditor has to make specific comment on various matters covered under an order notified by central government. (called MAOCAR order- more details can be seen in chapter on audit of companies). In it, the statutory auditor is required to evaluate the efficacy of internal audit system in cases of companies whose paid up capital exceed Rs. 25 lakhs or whose turnover on an average during the period of three years preceding financial years cross Rs 2 crores. Using the work of Internal audit by External Auditor: ‘The auditor can effectively make use of the work performed by internal auditor by planned co-ordination of his work. The auditor must judiciously use his work to his advantage. As regards to accounting system of the enterprise, the internal audit covers almost all areas of checking covered under external audit. However, the external auditor expresses his opinion on the truth and fairness of financial statements. Therefore the auditor has to evaluate the internal audit and decide whether its coverage of checking can lessen the extent of checking. The auditor has to evaluate the efficacy of internal audit system by assessing the professional competence of internal auditor, their independence in the organisation, audit coverage, actual work performed by them as evidenced by118 “A Hand Book of Practical Auditing their working files, reports etc. Depending upon the degree of reliance that he could place on it, the auditor can devise his nature, extent and timing of audit work. By liaisoning with internal auditor, the external auditor can have the co-operation of internal auditor in areas of routine checking, asset verification, checking of certain schedules, statements etc. For instance if the internal auditor vouches sales of certain months, the external auditor can ask his assistants to check certain other months and so on. Limitations of Internal Control The existence of internal control system in any entity provides good clues that aims of internal control viz., adherence to policy, safeguarding of assets, detection and prevention of errors/frauds, reliability and completeness of accounting data-might be achieved. One must not forget that clues that they are and not assertions guaranteeing the fulfilment of control objectives. Essentially, there are certain inherent limitations attached to internal control. SAP-6 of ICAI points out certain possible limitations. For instance, the internal control may not adequately cover all areas in view of cost considerations, it cannot foresee control mechanism for transactions of unusual nature, it cannot stand against deliberate circumvention of control procedures by management, false manipulation of transactions by the entity with tacit approval‘of management or ingenious breach of controls by staff by collusion or controls may become obsolete in changed scenario. Recognising this vital fact the auditor should proceed to evaluate the internal control. Evaluation of Internal Control The auditor has to decide whether he can place reliance on the internal control. If internal control is adequate, he can restrict nature, timing and extent of his checking accordingly. If not, he is left with no alternative but to resort to detailed checking. The auditor makes use of compliance procedure and substantive procedures in gathering evidence as to reliability of internal control system and data generated in accounting system. The methods of compliance procedure, and substantive procedures had been elaborately discussed in chapter I- (An Overview of Auditing). By resorting to compliance procedure, the auditor seeks to find out whether there exists good internal control system and whether such a system has operated with continuity throughout the period covered under audit. For this, the auditor studies the system in operation. He gains understanding as to how a transaction is processed and how the assets are handled. He evaluates the actual operation of the system against certain control criteria that must exist. Accordingly he decides whether the design of the system is adequate or not. Now he is concerned whether the system actually works out without break. For this he inspects documents flowing in the system. He makes enquiry with the persons involved in operation of the system. He tests the completeness, accuracy and validity of data generated in the accounting system of the entity by adopting substantive procedure. By inspection, enquiry or other methods the substantive checking point to actual practising of the system effectively or otherwise. The reliance the auditor can place’ on internal control is affected by badly designed system or ineffective operation of a good system. If the auditor finds out weakness in design or operation of internal control system, he reports them to.the management in what is called “letter of weakness”. The letter of weakness lists down the areas of weakness in the system and offers suggestions for improvement. It helps management to revise the system or to insist its strict implementation. It also acts as good defence for the auditor for any liability as it throws light on important limitation of his audit environment. The manner of evaluation of internal control may be in the following lines: making preliminary evaluation of the system to test the design of the system, compliance procedures to evaluate the adequacy and continuity of the system in practice and supplementing the compliance procedure with limited substantive procedures. For making preliminary evaluation, the auditor makes use ofInternal Control 119 the following techniques viz., narrative method, questionnaire method or flow.charting. Narrative « method describes the actual working-of the internal control-system-in an essay form. The audit assistants prepare their observation of the system. Narrative method of evaluation has certain limitations. It is lengthy. It may lack specificity and miss certain areas. It is not uniform and may vary according to persons preparing them. On the other hand, Internal control Questionnaire method makes use of well-structured specific questions covering each and every area of operation (like purchase, sales, stock-keeping, wage payment). Each question is framed with the aim. of assessing the strength of control at various stages of an operation. Generally the questions range over authorisation of transaction, flow of transaction, documents made use of in the flow, recording of transaction, division of work aiming at internal check, handling of assets, reporting of transactions ‘o management, and review of operations. Each question seeks responses in terms of *Yes' or No‘ or ‘Not applicable’. The questionaire are filled by responsible officials or by the auditor himself after having specific comments for each question from the staff or after having observation of the working of the system. The flow charting technique of preliminary evaluation gives out graphical description of the flow of each transaction, control points, forms.used etc. It depicts the direction f flow of transaction by marks of arrow, describes documents by figures with title, (indicating the points of their origin, route, storing or destruction) and indicates control points with symbols. Flow chart gives good visual description of sequence of transaction, inherent controls in it and documentary evidences generated in its occurrence. Next, for doing compliance and substantive procedures for ting the actual operation of the system, the auditor makes use of any one of the methods viz., - aspection, observation, inquiry, computation, analytical review suited to the occasion. QUESTIONS 1, Define internal control. Explain its objectives. 2. “The system of internal control. extends beyond those matters relate to the functions of accounting system”. (I.C.A.]). Explain the statement pointing out the matters in accounting as well as non-accounting system with which the internal control is concerned with. 3. State the aims of instituting control mechanism in a) accounting system and b) administrative system of an entity. 4. “Internal control in its whole gamut includes importantly the two forms of control devices viz., internal check and internal audit”. Discuss this, bringing out the inter-relationship among internal control, internal check and internal audit. S What is meant by internal check? What important points are to be borne in mind in devising good internal check system? internal check synonymous with internal control? strate how internal check could be introduced in respect of sales transactions of a business ty. ‘ine internal audit. What are the aims of having internal audit? management of XYZ co., Ltd., being a manufacturing company informs you that since = review of accounts, any way, is to be taken up by its statutory auditors, it feels unnecessary > create internal audit department. Moreover, creation of internal audit department entails manent overhead costs. Convince them about the utility of having internal audit. Present >em the benefits of having an external auditor as its internal auditor on a retainer basis. manner and extent of checking by an auditor is affected by the existence or otherwise of od internal control system- Discuss. Also set out the limitations of internal control system. =: an auditor evaluates the efficacy of internal control system? nat is a letter of weakness? Why is it issued? ;