Chapter 4. Internal Control, Internal Check and Internal Audit – Auditing: Principles and Techniques

Chapter 4

Internal Control, Internal Check and Internal Audit

CHAPTER OUTLINE
4.1 INTRODUCTION

An auditor must ensure that he fully understands the enterprise with which he is dealing before he determines his basic approach to an audit. He must familiarise himself with its organisation and comprehend the nature of the business. He must also ensure that he has thoroughly grasped any technicalities peculiar to the business. Only then will he be in a position to comprehend and identify the transactions which are being recorded in the accounting records and in relation to which the internal controls will be operating.

Formerly, business systems were usually installed with the object of getting work done by the cheapest and quickest methods available, but whilst these objects have not been lost sight of, it has been realised that establishment of the piecemeal methods of uncoordinated work process is ultimately neither cheap nor efficient. Overall planning is necessary to establish a flow of work through the whole business, enabling it to run smoothly and efficiently and with the added requirement that its assets shall be safeguarded at the same time.

This overall planning and its practical operation is included under the title of internal control which is established by the management. Although the auditor in his role as an auditor has no right to practice any particular method of control to be operated, he is virtually concerned with it, as the efficiency or otherwise of the internal control will greatly influence the auditor’s method of working.

4.2 INTERNAL CONTROL

4.2.1 Definition

Internal control refers to the various methods and procedures adopted for the control of production, distribution and the whole system (financial and non-financial) of the enterprise.

In other words, internal control system—the whole system of controls, financial or otherwise, established by the management in order to carry on the business of the enterprise in an orderly and efficient manner—ensures adherence to management policies, safeguards the assets and secures as far as possible the completeness and accuracy of the records.

The special report on internal control of the American Institute of the Certified Public Accountants and its statements on auditing procedures contain the following definition of internal control: “Internal control comprises the plan of organisation and all the coordinated methods and measures adopted within a business to safeguard its assets, check the accuracy and reliability of its accounting data, promote operations efficiency and encourage employees to follow prescribed managerial policies.”

In the opinion of 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 a business including internal check, internal audit and other forms of control.”

So, on the basis of above definitions, it may be stated that a system of internal control provides a measure for the management to obtain information, protection and control which are quite important for the successful working of a business organisation.

4.2.2 Basic Elements of Internal Control

An effective system of internal control should have the following basic elements:

  1. Financial and other organisational plans   This may take the form of a manual suitably classified by flow charts. It should specify the various duties and responsibilities of both management and staff, stating the powers of authorisation that reside with various members. This is important as in the event of staff absence or otherwise the correct flow of work and the internal control system could be vitiated by the wrong implementation of procedures by staff either innocently or willfully.

     

  2. Competent personnel   Personnel are the most important element of any internal control system. If the employees are competent and efficient in their assigned work, internal control system can be operated effectively even if some of the other elements of internal control system are absent.

     

  3. Division of work   This refers to the procedure of division of work properly among the employees of the organisation. Each and every work of the organisation should be divided in different stages and should be allocated to the employees in accordance with quality and skill.

     

  4. Separation of operational responsibility from record keeping   If each department of an organisation is being assigned to prepare its own records and reports, there may be a tendency to manipulate results for showing better performance. So, in order to ensure reliable records and information, record-keeping function is separated from the operational responsibility of the concerned department.

     

  5. Separation of the custody of assets from accounting   To protect against misuse of assets and their misappropriation, it is required that the custody of assets and their accounting should be done by separate persons. When a particular person performs both the functions, there is a chance of utilising the organisation’s assets for his personal interest and adjusting the records to relieve himself from the responsibility of the asset.

     

  6. Authorisation   Under the internal control system, all the activities must be authorised by a proper authority. The individual or group which can grant either specific or general authority for transactions should hold a position commensurate with the nature and significance of the transactions and the policy for such authority should be established by top management.

     

  7. Managerial supervision and review   The internal control system should be implemented and maintained in conformity with the environmental changes of the concern. By adapting any specific control system permanently, the extent to which the procedures of flexible controls have been followed in real practice should be observed and re-examined.

4.2.3 Objectives of Internal Control

Internal control is of fundamental importance to the auditor, because before he can plan the tests he intends to carry out in his audit programme, he must decide the extent to which he intends to rely on the system of internal control. But before depending upon the internal control system of the organisation, the auditor should ensure himself that the following objectives of internal control as per AAS-6 is achieved by the organisation:

Proper authorisation   Transactions are executed with management’s general and specific authorisation.

Prompt recording of transactions   All the transactions are promptly recorded in the correct amount in the appropriate accounts and in the accounting period in which they are executed so as to permit preparation of financial information within a framework of recognised accounting policies and to maintain accountability of assets.

Restricted access to assets   Access to assets is permitted only in accordance with management’s authorisation.

Actions against deviations   The recorded accountability for assets is compared with the existing assets at reasonable intervals and appropriate action is taken with regard to any differences.

4.2.4 Types of Internal Control

Internal control can be categorised as follows:

1. Organisational

An enterprise should have a plan of organisation which should (a) define and allocate responsibilities (every function should be in the charge of a specified person who might be called the responsible official) and (b) identify lines of reporting.

In all cases, the delegation of authority and responsibility should be clearly specified. An employee should always know the precise powers delegated to him, the extent of his authority and to whom he should report.

2. By segregation of duties

  1. No one person should be responsible for the recording and processing of a complete transaction.
  2. The involvement of several people reduces the risk of intentional manipulation or accidental error and increases the element of checking of work.
  3. Functions for a given transaction which should be separated include initiation, authorisation, execution, custody and recording.

3. Physical

  1. This concerns physical custody of assets and involves procedures designed to limit access to authorised personnel only.
  2. Access can be direct or indirect.
  3. These controls are especially important in case of valuable, portable, exchangeable or desirable assets.

4. By authorisation and approval

All transactions should require authorisation or approval by an appropriate person. The limits to these authorisations should be specified. For example, all credit sales must be approved by the credit control department or all overtime must be authorised by the works manager.

5. Arithmetical and accounting

  1. These are the controls in the recording function which check that the transactions have been authorised, that they are all included and that they are correctly recorded and accurately processed.
  2. Procedures include checking the arithmetical accuracy of the records, maintenance and checking of totals, reconciliation, control accounts, trial balances, accounting for documents and preview. Preview refers to the procedure in which before an important action involving the company’s property is taken, the person concerned should review the documents available to see that all that should have been done has been done.

6. By personnel

  1. Procedures should be designed to ensure that the personnel operating a system are competent and motivated to carry out the tasks assigned to them, as the proper functioning of a system depends upon the competence and integrity of the operating personnel.
  2. Measures include appropriate remuneration, promotion and career development prospects, selection of people with appropriate personal characteristics and training and assignment of tasks to the right level.

7. By supervision

All actions by all levels of staff should be supervised. The responsibility for supervision should be clearly laid down and communicated to the person being supervised.

8. By management

  1. These are controls, exercised by management, which are outside and over and above the day-to-day routine of the system.
  2. They include overall supervisory controls, review of management accounts, comparison with budgets, internal audit and any other special review procedures.

Advantages

The various advantages that may be derived from internal control system are summarised as follows:

  1. Identification of defects   Under internal control system, the total activities are segregated in such a way that the work preformed by one employee is automatically checked by another employee. So, if there is any defect in the system, it is easily detected.

     

  2. Flexibility   In this system, year-wise comparative analysis is done. So, if there is any change in the mode of operation, the changes in the system can easily be accommodated. Therefore, the opportunity for flexibility is available.

     

  3. Time savings   If the internal control system is in operation in an organisation, there is no need for the preparation of separate audit programmes for each and every audit engagement. Thus it saves time to a great extent.

     

  4. Lesser risk of omission   Under this system, the total work is sub-divided into a number of activities and each employee is assigned with a particular type of activity. So, there is least chance of oversight or omission of any matter.

     

  5. Provision for training facility   Due to lack of adequate experience, the auditor may face difficulty in establishing a close relationship between audit programme and the internal control system. This system itself provides training facilities to auditors to overcome this difficulty.

Disadvantages

It is also important to appreciate the following inherent limitations of internal control system:

  1. Chances of human error   The possibility of human error due to carelessness, mistakes of judgment or the misunderstanding of instructions may make the system ineffective.

     

  2. Cost   Management’s usual requirement is that a control procedure should be cost-effective. But in many cases, the cost of internal control procedure will not be proportionate to the potential loss due to fraud and error.

     

  3. Ignorance of unusual activity   It is a fact that most of the internal control techniques are directed towards anticipated types of transactions and not on unusual transactions.

     

  4. Collusion   There may be the possibility of circumvention of controls through collusion with parties outside the entity or with employees of the entity.

     

  5. Abuse of responsibility   It may happen that a person responsible for exercising control abuses his responsibility.

     

  6. Rigidity   There is the possibility that the system may become inadequate due to changes in the conditions, and compliance with procedures may deteriorate.

4.2.5 Evaluation of Internal Control

Evaluation of internal controls is fundamental to an audit. It is on the basis of this evaluation that the auditor will do the following:

  • Determine the nature and extent of his audit procedure, i.e. draw up his audit programme.
  • Draft letters of weaknesses, to draw the attention of the management to inform them about the weaknesses of the system.

Because of its importance, evaluation must be clearly distinguished from the process of ascertaining and recording the system.

Before taking up the work of audit in an organisation, the auditor should ascertain the authenticity of the internal control system existing in the organisation. He should evaluate the control system in order to determine whether he would depend on the internal control system or not and if so, to what extent he would depend on it.

The auditor himself should determine the process or procedure applying his own knowledge and judgment in the context of nature and size of the organisation under audit.

The auditor, while evaluating the system of internal control, should consider the following matters.

  • Whether the basic principles of internal control, which is prevailing in the organisation have been properly followed.
  • Whether the procedures which are stated from theoretical point of view have been properly implemented.
  • After definite interval of time, whether any changes are made in the system of internal control in the context of changed circumstances of the organisation.

On the basis of evaluation on the effectiveness of the internal audit system, the external auditor will decide the extent or degree of his reliance on the functioning of the internal audit system.

4.2.6 Internal Control and the Auditor

The Institute of Chartered Accountants of India in its Statement of Standard Auditing Practices (AAS-6) has stated the following.

“The duty of safeguarding the assets of a company is primarily that of the management and the auditor is entitled to rely upon the safeguards and internal controls instituted by the management, although he will of course take into account any deficiencies he may find therein, while drafting his programme.”

So far as the auditor is concerned, the examination and evaluation of 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. Internal control normally contributes to such assurance. The auditor should gain an understanding of the accounting system and related internal controls and should study and evaluate the operations of these internal controls upon which he wishes to rely in determining the nature, timing and extent of other audit procedures.

He can formulate his entire audit programme only after he has had a satisfactory understanding of the internal control systems and their actual operations. According to the American Institute of Certified Public Accountants, the auditor is required to make a proper review of the existing internal control and on the basis of such a review, the auditor should determine the resultant extent of the tests to which auditing procedures are to be restricted.

A proper understanding of the internal control system in its control and working also enable an auditor to decide upon the appropriate audit procedure to be applied in different areas that are covered in the audit programme. In a situation, where the internal controls are considered weak in some areas, the auditor might choose an audit procedure on test that otherwise might not be required; he might extend certain tests to cover a large number of transactions or other items than he otherwise would examine and at times he may perform additional tests for his satisfaction.

From the above, it can be concluded that the extent and nature of the audit programme is substantially influenced by the internal control system in operation. In deciding upon a plan of selective checking, the existence and operation of internal control system is of great significance.

4.2.7 Internal Control in Specific Areas of Business

This section is divided into the areas of activity usually found in a business. At the beginning of each area are stated the objectives of internal control in the area and some measures which will achieve the objectives then follow.

1. Internal control in general

Objectives   To carry on the business in an orderly and efficient manner, to ensure adherence to management policies, safeguard its assets, and secure the accuracy and reliability of the records.

Measures

  • An appropriate and integrated system of accounts and records
  • Internal controls over those accounts and record
  • Financial supervision and control by management, including budgetary control, management accounting reports, and interim accounts
  • Safeguarding and, if necessary, duplicating records
  • Engaging, training, allocating duties to specific staff who are capable of fulfilling their responsibilities, rotation of duties and cover for absences

2. Cash sales and collections

Objectives

  • To ensure that all cash, to which the enterprise is entitled, is received
  • To ensure that all such cash is properly accounted for and entered in the records
  • To ensure that all such cash is deposited promptly and is intact

Measures

  • Prescribing and limiting the number of persons who are authorised to receive cash, e.g., sales assistants, cashiers, etc.
  • Establishing a means of evidencing cash receipts, e.g., pre-numbered duplicate receipt forms, cash registers with sealed till rolls; the duplicate receipt books should be securely held and issue controlled
  • Ensuring that customers are aware that they must receive a receipt form or ensuring that the amount rung up on the cash register is clearly visible to the customer
  • Appointment of officers with responsibility for emptying cash registers at prescribed intervals, and agreeing the amount present with till roll totals or internal registers. Such collections should be evidenced in writing and be initialed by the assistant and the supervisor
  • Immediate and intact banking; payments should be made from funds drawn from the bank on an imprest system
  • Investigation of shortage and excesses
  • Independent comparison of agreed till roll totals with subsequent banking records
  • Rotation of duties and cover for holidays (which should be compulsory) and sickness
  • Collections by salesmen should be deposited in the bank promptly every day. There should be independent comparison of the amounts deposited with records of the salesmen
  • Persons handling cash should not have access to other cash funds or to sales ledger records

3. Payment into bank

Objectives

  • To ensure that all cash and cheques received is deposited in the bank promptly
  • To ensure that all cash and cheques received are deposited without delay at prescribed intervals, preferably daily
  • To ensure that all cash and cheques received are accounted for and recorded accordingly

Measures

  • Cash and cheques should be intact
  • Cash and cheques should be banked without delay
  • The bank paying-in-slip should be prepared by an official with no access to cash collection points or bought or sales ledger
  • Banking should be made with security in mind, e.g. for large cash deposits, security guards should be used
  • There should be independent comparison of paying-in-slips with collection records, post lists and sales ledger records

4. Cash balances

Objectives

  • To prevent misappropriation of cash
  • To prevent unauthorised cash payments

Measures

  • Establishment of cash floats of specified amounts and locations
  • Appointment of officials responsible for each cash transaction
  • Arrangement of security measures including use of safes and restriction of access
  • Use of imprest system with rules on reimbursement only against authorised vouchers
  • Strict rules on the authorising of cash payments
  • Independent cash counts on a regular and a surprise basis
  • Insurance arrangements, e.g. for cash balances and fidelity guarantee
  • Special rules for IOUs. Preferably these should not be permitted

5. Cheque payments

Objective

To prevent unauthorised payments being made from bank accounts

Measures

  • Control over custody and issue of unused cheque books. A register should be maintained if necessary
  • Appointment of an official to be responsible for the preparation of cheques or traders credits
  • Rules should be established for the presentation of supporting documents before cheques can be made. Such supporting documents may include goods receipt notes, orders, and invoices etc.
  • All such documents should be stamped ‘paid by cheque no…………’ with date
  • All cheques should be signed by at least two persons, with no person being permitted to sign if he is a payee
  • No cheques should be made bearer cheques except for the collection of wages or reimbursement of cash funds
  • All cheques should be strictly crossed
  • The signing of blank cheques must be prohibited
  • Special rules for authorising and checking direct debits and standing orders must be followed
  • Separating the duties of custody, recording and initiation of cheque payments

6. Purchases and trade creditors

Objectives

  • To ensure that goods and services are ordered only in the required quantity and quality and at the best terms available after appropriate requisition and approval
  • To ensure that goods and services received are inspected and only acceptable items are accepted
  • To ensure that all invoices are checked against authorised orders and receipts of the subject matter in good condition
  • To ensure that all goods and services invoiced are properly recorded in the books

Measures

  • There should be procedures for the requisitioning of goods and services only by specified personnel on specified forms with space for acknowledgement of performance.
  • Order forms should be pre-numbered and kept in safe custody. Issue of blank order form books should be controlled and recorded.
  • All goods received should be recorded on goods receipt notes or in a special book.
  • All goods should be inspected for proper condition and agreement with order and counted on receipt. The inspection should be acknowledged.
  • A listing of unfulfilled orders should be made and investigated at intervals.
  • Invoices should be checked for arithmetical accuracy, pricing, correct treatment of VAT, trade discount and agreement with order.
  • Total of entries in the invoice register or day book should be regularly checked.
  • Responsibility for purchase ledger entries should be vested in personnel separate from personnel responsible for ordering, receipts of goods and the invoice register.
  • The purchase ledger should be subject to frequent reconciliation in total or be checked by an independent senior official.
  • Ledger account balances should be regularly compared with the supplier’s statements of account.
  • Cut-off procedures at the year-end are essential.
  • A proper coding system is required for purchase of goods and services so that correct nominal accounts are debited.

7. Sales and debtors

Objectives

  • To ensure that all customers’ orders are promptly executed
  • To ensure that sales on credit are made only to bona fide goods credit risks
  • To ensure that all sales on credit are invoiced, that authorised prices are charged and that before issue all invoices are completed and checked as regards price, trade discounts and VAT
  • To ensure that all invoices raised are entered in the books
  • To ensure that all customers’ claims are fully investigated before credit notes are issued
  • To ensure that every effort is made to collect all debts

Measures

  • Incoming orders should be recorded, and if necessary, acknowledged, on pre-numbered forms. Orders should be matched with invoices and lists of outstanding orders prepared at intervals for management action. Sequence checks should be made regularly by a senior official.
  • There should be procedures laid down for verifying the credit worthiness of all persons or enterprises requesting goods on credit. A credit limit should be established.
  • Selling prices should be prescribed. Policies should be laid down on credit term, trade and cash discounts and special prices.
  • Invoicing should be carried out by a separate department. Invoices should be prenumbered and the custody and issue of unused invoice books controlled and recorded.
  • All invoices should be independently checked for agreement with customer order, with the goods despatched records, for pricing, discounts, VAT and other details. All actions should be acknowledged by signature or initials.
  • Accounting for sales and debtors should be segregated by employing separate staff for cash, invoice register, sales ledger entries and statement preparation.
  • Sales invoices should be pre-listed before entry into the invoice register or day book and the pre-list total independently compared with the total of the register.
  • Customer claims should be recorded and investigated. Similar controls should be applied to credit notes. At the end of the year, all unclear claims should be carefully investigated and assessed.
  • A control account should be regularly and independently prepared.
  • All balances must be reviewed regularly by an independent official to identify and investigate overdue accounts, debtors paying by instalments, and accounts where payments do not match with the invoices.
  • Bad debts should be written off only after due investigation and acknowledged authorisation by senior management.
  • At the year end, an analysis of debtors should be prepared to evaluate the need for a doubtful debt provision.

4.2.8 Internal Control Questionnaire

An internal control questionnaire is basically a comprehensive list of questions, covering every aspect of the client’s system, the answers to which will enable the auditor to assess the internal controls in operation. To facilitate the assessment, the questions are asked in a form whereby the answer ‘yes’ is satisfactory, whereas the answer ‘no’ appears to indicate a weakness.

Basic characteristics of internal control questionnaire

  1. The internal control questionnaires will be drafted as far as possible in a form whereby the questions can be answered simply with a “yes/no/not applicable”.
  2. Though internal control questionnaires are normally in a standardised preprinted form for particular types of enterprises, their application to individual clients in a skilled matter requires the attention of senior staff.
  3. The internal control questionnaires will require reviewing and updating at regular intervals and on the basis of changing situations amendments are required to be made to the system.
  4. Staff responsible for the completion or review of internal control questionnaires should be required to sign and date them. This fixes both the responsibility and indicates the date the answers to questions were obtained.
  5. The answers ‘No’ will require attention at the subsequent evaluation stage. They will also frequently require cross-reference to systems notes and letter of weaknesses, as well as to the internal control evaluation.

Typical questions to be found in an internal control questionnaire

  1. In respect to stocks and work-in-progress
    1. Are stocks kept in proper storage accommodation which protects them against the following risks?
      1. deterioration
      2. access by unauthorised persons
      3. other risks (e.g. fire)
    2. Is there an adequate system in operation in respect of goods received to ensure the following?
      1. That the goods are checked for quantity and quality
      2. That the goods are properly mentioned in the records
    3. Are all stock issues from stores made only against properly authorised requisitions?
    4. By whom can requisitions be authorised?
    5. Are bin cards or equivalent records maintained at the stores?
    6. Are perpetual inventory records maintained in respect of both quantity and value for the following items?
      1. raw materials
      2. components
      3. finished goods
      4. consumable stores
    7. Are store records maintained by persons independent of the following?
      1. the storekeepers
      2. the persons responsible for actually checking the physical stocks
    8. Are the physical stock quantities regularly counted and reconciled with the stores records by persons independent of the storekeepers? Do they state approximate frequency of reconciliation?
    9. Are all material discrepancies independently investigated revealed?
    10. Are stores records amended to agree with actual quantities?
    11. Are there proper arrangements in operation for writing down stocks that are
      1. defective,
      2. obsolete or
      3. slow-moving?
    12. Is the costing system fully integrated with the financial accounting records?
    13. Is there a sound system in operation for charging direct costs to work-in-progress accounts?
    14. Does the system clearly distinguish between fixed and variable overheads?
    15. Does the treatment of overheads comply with the requirements of generally accepted accounting principles?
    16. Does the system ensure that excess costs are written off and not included in work-in progress?
    17. Has adequate insurance been taken out in respect of the following catastrophe?
      1. theft,
      2. fire or
      3. other risks (eg. flood)
  2. In respect of fixed assets
    1. Are registers of fixed assets maintained, showing adequate details of all material assets?
    2. Are regular physical inspections done to ensure the continued existence and to confirm the condition of assets by responsible officials other than those who
      1. maintain registers of fixed assets and
      2. have custody of fixed assets?
    3. Is there a proper system for distinguishing between capital and revenue expenditure?
    4. By whom is capital expenditure authorised? Give details of who may authorise capital expenditure, and the precise limits of their authority.
    5. Is the authorisation of capital expenditure properly evidenced?
    6. By whom is the sale or scrapping of fixed assets authorised? Give details of who may authorise the sale or scrapping of fixed assets and the precise limits of their authority.
    7. Is the authorisation of the sale or scrapping of fixed assets properly evidenced?
    8. When fixed assets are sold or scrapped, are there controls in force to ensure the following?
      1. appropriate entries are made in the accounting records and registers
      2. receipts for sale are properly accounted for
    9. Are the rates of depreciation for the major classes of fixed assets adequate?
    10. Do the rates of depreciation take due account of obsolescence?
    11. Is the system adequate to ensure the correct calculation of depreciation in respect of individual assets?
    12. Are the balances on the asset register regularly reconciled with the accounting records?

Note: It is difficult to draft a standardised questionnaire of different items of internal control, because there are a number of methods of controlling the business internally. However, the above illustrative questionnaires have been given to give an idea about the internal control questionnaire.

4.3 INTERNAL CHECK

4.3.1 Definition

Internal check is an arrangement of the duties of the staff members of the accounting functions in such a way that the work performed by a person is automatically checked by another.

In the opinion of Spicer and Pegler, “a system of internal check is an arrangement of staff duties, whereby no one person is allowed to carry through and to record every aspect of a transaction, so that without collusion between two or more persons, fraud is activated and at the same time the possibilities of errors are reduced to the minimum.”

Internal check has been defined by the Institute of Chartered Accountants of England and Wales as “the checks on day to day transactions which operate continuously as part of the routine system, where the work of one person is proved independently or in complementary to the work of another, the object being the prevention or early detection of errors or frauds.”

On the basis of the above definitions, it may be concluded that “internal check is a system where the work is divided amongst the employees in such a manner that no single individual is allowed to carry on the whole function from the beginning to the end and the work of an individual is being automatically checked by another.”

4.3.2 General Considerations in Framing a System of Internal Check

Following factors are required to be considered in framing a system of internal check:

  1. Work assignment   No single person should be given the total part of a particular work. All dealings and acts of every employee should, in the ordinary course, come under the review of another.

     

  2. Rotation of employees   The duties of members of the staff should be changed from time to time without any previous notice, so that the same officer or subordinate does not, without a break, perform the same function for a considerable length of time.

     

  3. Compulsory leave   Every member of the staff should be encouraged to go on leave at least once in a year. Experience has shown that frauds successfully concealed by the employees are often detected when they are on leave.

     

  4. Separation of inter-related jobs   Persons having physical custody of assets must not be permitted to have access to the books of accounts.

     

  5. Uses of mechanical devices   To prevent loss or misappropriation of cash, mechanical devices such as the automatic cash register should be employed.

     

  6. Periodical review   The financial and administrative power should be distributed very judiciously among different officers and in such manners that those which are actually exercised should be reviewed periodically.

     

  7. Responsibility   Responsibility of each individual must be properly defined and fixed. The work of the business should be allocated amongst various staff members in such a manner that their duties and responsibilities are clearly and judiciously divided.

     

  8. Safeguards   For stock taking at the end of the year, trading activities should, if possible, be suspended. The task of stock taking and evaluation should be done by staff belonging to several sections of the organisation. It may prove dangerous to depend exclusively on the stock section staff for these tasks since they may be tempted to under and/or overstate the stock.

     

  9. Supervision   A strict supervision should be exercised to ensure that the prescribed internal checks and procedures are fully operative.

     

  10. Reliance   No staff member of the business should be relied upon too much. The system must provide for an automatic checking of the work of every employee by another employee.

4.3.3 Objectives of Internal Check

The objects of internal check system can be set forth as under.

  1. Assigning responsibility   To allocate the duties and responsibilities of every employee in such a manner that they may be identified and held responsible for a particular error or fraud

     

  2. Minimising error or fraud   To minimise the possibility of any error or fraud done by any staff member

     

  3. Detecting errors or frauds   To detect errors or frauds easily due to independent checking of work done by one employee by another employee

     

  4. Reducing clerical mistakes   To minimise the possibility of omission of any transaction from being recorded in the books of accounts

     

  5. Enhancing work efficiency   To enhance the efficiency of the staff, as the management of duties is based on the principle of division of labour

     

  6. Obtaining confirmation   To obtain confirmation of facts and entries, physical and financial, by the presentation and necessary maintenance of records

     

  7. Reducing burden of work   To reduce the burden of the work of independent auditor by introducing the internal check system in a scientific way

     

  8. Exercising moral pressure   To exercise moral pressure on the employees by introducing continuous review process of the total system

     

  9. Ensuring reliability   To facilitate business control by ensuring the reliability of accounting records and books

     

  10. Obtaining supervision advantages To obtain the advantages of supervising the various assets, inflow and outflow of cash and goods of the business

Advantages of internal check

The advantages that can be derived from internal check can be discussed from different points of view as follows:

  1. From business point of view

    The advantages from business point of view are as follows:

    1. Proper allocation of work: Rational allocation of work among the different staff members of the organisation brings precision in work.
    2. Control device: The distribution of work under this system is such that it acts as a control device against unscrupulous employees. The chances of fraudulent manipulation are thus minimised due to the existence of this check.
    3. Speedy work: As the individual staff is engaged in the same type of jobs for a considerable period of time, it results in the efficient performance of the activities and high speed of work.
    4. Increase in efficiency and skill: A good system of internal check increases the efficiency of work among the staff due to its proper planning for assigning the right job to the right person.
    5. Easy preparation of final accounts: Since no individual worker is allowed to handle a job completely and the work is divided among the employees in a proper manner, the books of accounts can be kept up to date; as a result, the final accounts can be prepared easily.
    6. Creation of moral check: Knowledge of subsequent checking of each employee’s work by another acts as a great check to commission of errors and frauds.
  2. From the owner’s point of view
    1. Reliability on accounts: If there is a good system of internal check, the owner of the concern may rely upon the genuineness and accuracy of the accounts.
    2. Orientation of accounting: As the responsibility of each staff is clearly defined and fixed, it develops a system of accounting which is known as responsibility accounting.
    3. Economical operation: Although it seems that the introduction of well-integrated system of internal check is costly, in actual practice it is observed that the staff patterns are so arranged that the existing staff be properly filled in different operating areas involving no extra cost.
  3. From the auditor’s point of view
    1. Facilitation of audit work: Sound and efficient internal check system may facilitate to a greater extent, the work of the auditor by relying on ‘test check’.
    2. Attention to other important matters: As the auditor gains confidence on the internal check system, he can avoid the basic routine checking work to some extent and can give attention to other important matters.

4.3.4 Shortcomings of Internal Check System

Dependence on each other proves fatal in the quick disposal of the work. If one person is absent, the day-to-day work will be seriously disrupted. This is the main shortcoming of the internal check system.

Following are some more shortcomings of internal check system:

  1. Monotony   Involvement in the same kind of work may result in monotonous attitude on the part of the person who is engaged in the same type of job.

     

  2. Carelessness   The possibility of some of the responsible and high level officials being complacent increases, as they believe (though it is not always right) that under a sound system of internal check nothing can go wrong.

     

  3. Collusion   The real purpose of the internal check is bound to fail if collusion among the staff exists in disguise.

     

  4. Limited application   The application of this system is limited only in big organisations. Its application in small organisations may result in loss of time and cause unnecessary expenditure.

     

  5. Dependence   Statutory auditors in almost all cases rely on the internal check system. Accordingly they apply test check and not a thorough check.

     

  6. Possibility of disorder   In the absence of a properly organised system of internal check, there will be chaos and disorder in the working of a business.

4.3.5 Safeguard Against the Shortcomings of Internal Check

The advantages of the internal check system outweigh its disadvantages. Hence the wide acceptability of the system in the conduct of an audit is appreciated. The stated defects of the system, however, may be overcome if the management is careful in its effective implementation. The payment of proper incentives to staff may remove the carelessness of the staff to a great extent. The monotony of a job may be avoided by inter-departmental transfer of the employees. Regarding the collusion, it can be stated that the whole system is bound to fail if the morality of the employees deteriorates. General punishments like fine, termination of service etc. may temporarily check collusion, but without upgrading the morality of the staff, it is not possible to stop collusion permanently.

4.3.6 Internal Check and the Auditor

The basic responsibility of the auditor is to certify the fairness and authenticity of the accounts of the business. For this, the auditor is expected to discharge his duties in such a way as would reveal the actual state of affairs of the business. It is true that an efficient system of internal check can make his work easy and convenient. He may be relieved of detailed checking of the transactions. But to what extent an auditor should depend on the system of internal check is solely a matter of his own discretion. Though the auditor conducts the examination of the accounts independently, he has to depend a lot on the system of the business. Because it becomes practically impossible for the auditor to conduct the examination of accounts thoroughly after the close of the financial accounts.

Where the system of the internal check is not in operation, it is desirable that the auditor should adopt the detailed checking of transactions irrespective of the type of organisation and the volume of transactions. In order to save his time, if he adopts the method of test checking of few transactions and if errors and frauds are detected later on, the auditor will be held responsible. But where the internal check system is in operation and for this where detailed checking is not necessary, in that case to what extent the auditor would depend on internal check system is a matter of consideration.

If through review the auditor thinks that the system of internal check is adequate and free from errors he can depend on the system, and instead of detailed checking he can resort to test checking. But if he observes any weakness in the system, he should not depend on this and conduct his work extensively and in detail.

So, the auditor is expected to apply proper judgement with reasonable care and skill to appraise the system. Thus, he has to determine to what extent he would depend on internal check system. Hence, it is clear that the internal check system does not reduce the liability of the auditor.

4.3.7 General Principles of Internal Check for a Few Transactions

Aspects like cash sales, cash receipts, cash payments, payment of wages, credit purchases, credit sales, stores, and material wastage form important parts in the procedure and conduct of an audit. These matters are important in the sense that fraudulent manipulations or frauds and errors in those areas are bound to prevail unless there exists an efficient system of internal check as regards the above. So, the principles of internal check as regards the stated areas are detailed in the following paragraphs. It should be noted in this context that the application of the principles in actual practice depends upon the nature and size of the organisation as well as in relation to the concept of materiality.

1. Internal check as regards movement of materials

Each and every organisation may have to preserve and maintain the stores of different kinds, viz. finished goods, semi-finished goods and the raw materials, in a proper way. As such, there should be a strict control over these items in order to safeguard against pilferage, theft or misuse. A suitable system of internal check should be devised for stores to ensure correct records, prevent theft and to reduce wastage. The system of internal check to be introduced in this respect may be outlined as follows:

  1. Receipts of goods in stores
    1. Store should be located at a convenient place. It should have an adequate storage facility, so that the goods may not be wasted or misplaced or misused.
    2. The storekeeper will submit the requisition to the purchase department in order to purchase the necessary goods and store them.
    3. On receipt of the goods purchased, the storekeeper will prepare a goods received note in triplicate—one for purchase department, one for accounts department and third for the stores department itself.
    4. The goods received should be recorded in goods inward book by the accounts department and in the Bin card by the stores department.
    5. After the receipt of goods, they should be properly inspected before they are placed in stores.
  2. Delivery of goods from stores
    1. In order to issue different types of stores to the different departments, the proper requisition should be submitted on behalf of the departmental authority.
    2. For sale of goods, unless the delivery orders are received from the sales department, goods will not be sent to the customers.
    3. Requisition forms of different colours should be used for different departments.
    4. The goods, which are to be issued from stores, should be recorded in goods outward book.
    5. If any goods are returned to stores, a goods return note is to be prepared and recorded in that book.
  3. Accounting of store movements
    1. Responsibility for accounting of stores should be assigned to an efficient accountant.
    2. For each type of goods, separate store ledgers should be maintained.
    3. For accounting of movement of stores of each item, bin card should be used.
    4. After a fixed interval of time, the store ledger should be verified with the bin card in order to find out discrepancies, if any.
  4. Counting and maintenance of stores
    1. For each type of stores, a separate list is to be prepared. The list should incorporate the quantity of goods, rate of acquisition and the actual value.
    2. An employee, who is not in relation with the maintenance of stores, should be entrusted with the counting of stores.
    3. For counting various types of stores, separate employees are to be engaged.
    4. The task of recording the rate of valuation of stores and the actual value in the proper column of the stock sheet should be assigned to a responsible employee.
    5. Those who prepare the stock sheets should put their signature on it. The counting and addition of the stock sheet should be verified by a separate employee.
    6. After verifying thoroughly, the stock sheet should be signed by higher officials.
  5. Preservation of stores
    1. A separate but proper place should be earmarked for each type of stock.
    2. A separate code number should be used for different classes of stocks.
    3. The stock should be frequently counted and checked by a responsible official, who should also compare the bin cards with the stores ledger.
    4. If there is any difference between actual stock and the stock as shown in books, it should be adjusted or written off with the approval of the proper authority.
    5. Stock taking should be conducted at the end of the period or at irregular intervals during the period, if necessary.
    6. A responsible official should examine whether proper security measures have been adopted for the preservation of stores. If any defect or drawback is found in the system, it should be brought to the notice of the appropriate authority.

2. Internal check as regards to wage payments

The system of internal check for wages should be devised in a careful and planned way, especially in a manufacturing concern. Usually, wages are paid to the workers on the basis of time spent by each worker in the production process. So, correct recording of time is essential for the purpose of determining proper wages. For the purpose of efficient control over the payment of wages, a separate wage department headed by responsible official of the organisation should be there.

For the purpose of recording correct time and to avoid frauds and errors, different time recording devices are used. To implement the effective internal check system for wage payment, it is suggested that the following system be introduced.

  1. Maintenance of wage records
    1. Time work recording: Workers are paid their wages normally on the basis of time. Thus the time spent by each worker should be correctly recorded in the time record-book and for this purpose the following methods are used:
      • Time Recording Clock: At the time of entering into the factory the worker puts his entry card in the slot of time recording clock, kept at the entry of the gate. The clock records the date and the actual time of his entry in the factory. At the time of leaving the factory, he has to put his card in the slot of the clock again for recording his actual time of departure.
      • Brass Metal Token: Under this system, each worker is given a brass metal token duly numbered. The workers at the time of entering into the factory put their respective token in the appropriate place of the board. On the basis of this token, the timekeeper records the attendance of the worker in the attendance register.
      • Attendance Card: Here, the workers are given attendance cards. At the time of entering into the factory, the workers put their attendance cards in the box kept near the gate. The gatekeeper collects the same for the purpose of recording time in the attendance register.
    2. Piece work recording: When the workers are paid on the basis of work performed, they are provided with cards known as ‘job cards’ which contain all information relating to workers and their jobs, viz the name of the worker, nature of work allotted, the volume of work done and the wage or job rate. This card is checked by the piecework reviewer along with the quality and quantity of goods. This card helps in the preparation of wage sheet.
    3. Overtime recording: The question of payment for overtime to workers arises only when it is sanctioned by the proper authority. The overtime slip is to be given to each worker, who has been allowed to do the same. This slip contains various information, viz. the name of the workers, details about the job and the rate at which wages are to be paid. The overtime record should be maintained separately and it should be passed either by foreman or by the works manager. After that, the slip should be sent to the accounts department for the preparation of wage sheet.
    4. Pass-out recording. Normally the workers are not allowed to leave the factory during the hours of work. Sometimes the workers are compelled to leave the factory during the working period on some personal grounds. In that case, pass-out slips are to be issued to the workers. Two copies of the slip are prepared. The original copy is to be handed over to the workers who at the time of leaving the factory hand over the same to the gatekeeper and the other copy is to be sent to the wage department for the preparation of wage sheet.
  2. Preparation of wage sheets

    The preparation of wage sheets should be done by a separate department. This work should be assigned to a number of employees of the wage department to minimise the irregularities. Information regarding attendance is available from the attendance registers, job cards, overtime ships, pass-out ships etc. For time workers and piece workers, separate wage sheets should be prepared.

    All essential particulars should be entered in the wage sheet, which should have separate columns for

    1. Name of the worker
    2. Identification number alloted and the department in which he is working
    3. Total time worked in the production process
    4. Details of work done
    5. Applicable rate of wages
    6. Total amount of wages payable
    7. Bonus entitlement, if applicable
    8. Overtime wages, if any
    9. Deductions
    10. Net amount of wages payable

    The total process of wage sheet preparation can be divided into different parts to be done by separate staff of the wage department. This process can be implemented in the following ways.

    1. An employee of the department should examine the time and piece wage records, overtime records and other statements relating to wage payment.
    2. One employee should prepare individual worker’s statement of wage payment.
    3. Another employee should check the calculations and deductions.
    4. One other employee should check the whole work thoroughly.
    5. All the employees involved in the process should put their initials on the wage sheets and finally the wages sheets should be forwarded to the cash department for payment by some responsible official.
  3. Payment of wages
    1. The employees associated with the preparation of wage sheets must not be given the assignment of making payment of wages to avoid collusion between them.
    2. On receipt of wage sheets from the wage department, the chief cashier makes necessary arrangements with the bank for the withdrawal of necessary cash for payment.
    3. Each worker, who is to receive the wages, should be present personally. Thumb impression may be taken as an evidence of wage receipt by the workers.
    4. The foreman or the concerned officer of each department should be present at the time of payment to identify the worker.
    5. Proper arrangements should be made with regard to unclaimed wages.
    6. Advances to the workers should be discouraged, and if it becomes unavoidable, they should be given and these should be deducted later on from the wages of the respective workers.

3. Internal check system as regards to purchase

Purchases are of two types—cash purchase and credit purchase. The internal check as regards cash purchase is quite simple in comparison with credit purchase. The internal check as regard cash and credit purchases is elaborated as follows:

  1. Purchase requisition   No purchase should be made without purchase requisition slip issued by the stores department. The procedure for issuing purchase requisitions should be specified. The details about the quantity, quality and the time by which the goods must be supplied must be clearly mentioned in the requisition slip.

     

  2. Enquiry for purchase   In order to purchase the required item, the purchase department makes an enquiry about the terms and conditions of purchases from different suppliers. For this purpose, tenders are generally invited and usually tenders having the lowest price are accepted.

     

  3. Purchase order   The purchase manager or any other authorised officer of the organisation should be entrusted with the sole authority to issue purchase order. One original and other three copies of the order should be prepared. The original purchase order is to be sent to the supplier. The first copy should be sent to the stores department; the second copy to the accounts department and the last copy is to be retained by the purchase department for reference.

     

  4. Receipts of goods   All the goods received from the supplier are to be checked as per the copy of the purchase order and the challans of the suppliers. Goods receipt register is to be maintained for the purpose of recording the receipts of the goods after proper inspection regarding their quantity and quality either at the stores department or any centralised godown of the concern. All invoices received from the supplier are to be entered in the purchase day book after proper scrutiny.

     

  5. Making payment   The purchase department should thoroughly check the invoices and send the same to the accounts department for payment. The accounts department should compare the invoice with the purchase order and should also check the calculations. Only responsible officials should draw cheque for the payment of invoice, which are to be marked as ‘PAID’ after payment. All payments are to be made against “A/c payee cheque.”

4. Internal check system as regards to sales

Sales are the most important source of income in a business organisation. In case of most of the business organisations, they are the only source of income. Therefore, the system of internal check to be adopted for sales should be extremely effective.

The system of internal check regarding sales should take care of the following aspects:

  1. Independent sales department   There should be a separate and independent sales department, which should function as a composite of several sub-departments. Sales manager or a senior competent officer should be in charge of the department.

     

  2. Receipts of orders   On receipt of an order, it should be numbered and preserved in orders received book with full details of the order. A confirmatory written order should be obtained against verbal orders. The despatch department should be given a copy of the order with necessary particulars.

     

  3. Packing of goods   Packing of the goods should be made by the despatch department as per the copy of the sales order, and accordingly a separate statement showing the goods packed should be prepared by the department.

     

  4. Preparation of invoices   The statement of goods as prepared by the despatch department should be checked with the customers’ orders and then the invoice should be prepared in triplicate.

     

  5. Checking of invoices   A responsible official should be assigned to check the invoice, particularly the rates charged and the calculations made. He should also see that the terms and conditions in the order have been duly followed and there is no scope for complaint by the customer. He should then put his initial on the invoice.

     

  6. Despatching the goods   With the help of the copy of invoices, entries should be made in the sales day book. On despatch of the goods, records should be made in the goods outward book. Two copies of the invoice may be sent to the customer who will return one of them after signing it.

5. Internal check system as regards to cash receipts

The risk of misappropriation of cash needs no emphasis. The chances of fraud are numerous in cash transactions. In order to reduce the chances of fraud in cash transactions, the internal check system as regards the cash receipts should be very effective and should take into consideration the following principles of internal check for cash transactions:

  1. Separation of duties   The cashier should have no access to the ledgers and other books of original entry except the rough cashbook that is required for spot recording of cash receipts.

     

  2. Control over receipts book   The printed receipts book, serially numbered, should be used as and when cash is collected and the same should be countersigned by the responsible manager. The unused receipt book should be kept in safe custody.

     

  3. Handling of incoming remittances   Incoming correspondences including all remittances should be opened by the cashier in the presence of a responsible officer of the concern. All receipts of cheques should be marked, by means of a rubber stamp as A/c payee only.

     

  4. Depositing cash into bank   All collections, both cash and cheque, should be deposited into bank daily. The counter-foil portion of the paying-in-slip should be filled by the clerk and the portion that is to be retained by the bank should be filled in by the cashier.

     

  5. Reconciling bank statement   Bank reconciliation statement should be prepared at regular intervals by the cashier to know the actual position of bank balances.

     

  6. Correction of the cash book   Any spoiled slip should be marked cancelled and should not be turned out and be removed from the receipt book. For the purpose of altering words or figures, overwriting should be discouraged and fresh writing with proper initial is encouraged.

6. Internal check system as regards cash payments

The principles of internal check as regards payments of cash can be set forth as follows:

  1. Payments through cheques   Generally all payments should be made by account payee cheques.

     

  2. Separation of duties   The person in charge of making payments should have no connection with the receipts of cash.

     

  3. Proper authorisation   It should be seen that all cheques have been duly signed by the authorised person and no payments exceeding the amount of Rs. 20,000 should be made without A/c payee cheque. It is according to the provision of Section 40A(3) of the Income Tax Act, 1961 that any sum exceeding Rs. 20,000 is to be paid by a crossed cheque, otherwise the expenses will not be allowed as deductions in computing business income.

     

  4. Safety measures for unused cheques   All the unused cheques should be kept in proper safe custody.

     

  5. Control over payment vouchers   Arrangements should be made to ensure that the vouchers supporting payments are not presented twice for payment. Such vouchers should be stamped as ‘paid’ before the cheques are signed.

     

  6. Confirmation with the creditors   An official should check the statement received from creditors and verify with the invoices and ledger accounts. Only after proper verification, the cheques should be drawn in favour of the creditors. Confirmation of accounts with the creditors should also be made through direct correspondence.

     

  7. Cash discount   To ensure the availability of cash discounts, monthly or periodic payments should be made on the fixed dates.

     

  8. Reconciliation of bank balance   Bank reconciliation statements should be prepared to reconcile bank and cash balances from time to time by some authorities other than the cashier.
4.4 INTERNAL AUDIT

4.4.1 Definition

Internal audit refers to an independent appraisal of activity within an organisation for the review of accounting, financial and other business practices. It consists of a continuous and critical review of financial and operating activities by a staff of auditors functioning as a part of the management and reporting to it and not to the shareholders.

According to W.B. Meigs, “internal auditing consists of a continuous and critical review of financial and operating activities by a staff of auditors functioning as full time salaried employees.”

According to the Institute of Internal Auditors, USA. “Internal auditing is an independent appraisal function established within an organisation to examine and evaluate its activities as a service to the organisation.”

As per AAS-7, “internal audit is a separate part of internal control system. The objective of internal audit is to determine whether other internal control systems are well designed and properly operated. Internal auditor is appointed by the management and is part of overall organisation system of internal control”.

So, internal audit can be defined as “an independent appraisal function established by the management of an organisation for the review of internal control system as a service to the organisation. It objectively examines, evaluates and reports on the adequacy of internal control as a contribution to the proper, economic, efficient and effective use of resources”.

In fact, internal audit is a special type of control. It deals primarily with accounting and financial matters. The work of the internal auditor is more or less same as that of an external auditor. The internal auditor has to make an effort to find out the weaknesses of the internal control system in operation and suggest necessary improvements.

4.4.2 Basic Principles of Establishing Internal Auditing in a Business Concern

Following are the basic principles required to be considered before establishing internal auditing in a business concern.

  1. Independent Status   The internal audit department should have an independent status in the organisation. The internal auditor must have sufficiently high status in the organisation. He may be required to report directly to the board of directors.

     

  2. Scope of audit   The scope of internal audit department must be specified in a comprehensive manner to the extent practicable. In fact, the department must have the authority to investigate from a financial angle every phase of organisational activity.

     

  3. Clear objectives   It must have an unambiguous and clear understanding of the objectives on each assignment given to it from time to time.

     

  4. Formation of the department   The management should take care in selecting the staff of the internal audit department. The size and qualification of the staff of the internal audit department should be commensurate with the size of the business organisation.

     

  5. Time bound programme   The programme of the internal auditor should be time bound with the provision for periodic reporting.

     

  6. Internal audit report   The copy of the report of the internal auditor should be made available to the statutory auditor.

     

  7. Follow up action   There must exist a specific procedure to follow up the report submitted by the internal audit department.

     

  8. Performance of executive actions   The internal audit department should not be involved in performance of executive actions.

4.4.3 Scope and Objectives of Internal Audit

The primary objective of internal audit lies in helping the management attain maximum efficiency by providing an important source of review of operations and records for the assistance of all levels of management.

As per AAS-7, following are the objectives of internal audit:

  • Review of accounting system and related internal control
  • Examination of financial and operating system
  • Examination of effectiveness and efficiency of financial control
  • Physical examination and verification

Thus, internal audit carries out a thorough examination of the accounting transactions as well as that of the system according to which these have been recorded with a view to reassuring the management that the accounts are being properly maintained. It also ensures that the system contains adequate safeguards to check any leakage of revenue or misappropriation of property and the operations have been carried out in conformity with the plans of the management.

So, the objectives of an internal audit can be stated as follows:

  1. Accuracy in accounts   To verify the accuracy and authenticity of the financial accounting and other records presented to the management.

     

  2. Adoption of standard accounting practices   To ascertain that the standard accounting practices, as have been decided to be followed by the organisation, are being adhered to.

     

  3. Proper authority on assets   To establish that there is a proper authority for every acquisition, retirement and disposal of assets.

     

  4. Confirmation of liabilities   To confirm that liabilities have been incurred only for the legitimate activities of the organisation.

     

  5. Analysis of internal check system   To analyse and improve the system of internal check to see whether it is working properly and effectively and whether the system is economical.

     

  6. Prevention and detection of fraud   To implement such techniques in the conduct of the internal audit so that it can detect and prevent frauds in the accounts.

     

  7. Provision for new ideas   To provide a channel whereby new ideas can be brought to the attention of the management.

     

  8. Review of the operation of internal control system   To review the operation of the overall internal control system and to bring material departures and non-compliance to the notice of the appropriate level of management.

     

  9. Special investigation   To provide scope and make avenues for special investigations for the management.

     

  10. Review of organisational activities   To review the operations carried out in the organisation to assure the management that they are being carried out in compliance with the management objectives, policies and plans.

4.4.4 Functions of Internal Audit

Very large organisations (and some small ones) have found need for internal audit in addition to external audit. Internal auditors are employees of the organisation and work exclusively for the organisation. Their functions partly overlap those of the external auditors and in part are quite different.

The functions of internal auditors can be described as follows:

1. An appraisal function

The internal auditor’s job is to appraise the activity of others, not to perform a specific part of data processing. For example, a person who spends his time checking employee expense claims is not performing an internal audit function. But an employee who spends some time reviewing the system of checking employee expense claims may well be performing an internal audit function.

2. As a service to the organisation

The management requires that the auditor ensures the following:

  1. That its policies are fulfilled
  2. That the information it requires to manage effectively is reliable and complete; this information is not only that which is provided by the accounting system.
  3. That the organisation’s assets are safeguarded
  4. That the internal control system is well designed
  5. That the internal control system works in practice.

The internal auditor’s activities will be directed to ensure that these requirements are met. The internal auditor can be seen as the eye of the board within the enterprise.

3. Other duties

Other duties may include the following matters.

  • Being concerned with the implementation of social responsibility policies adopted by top management
  • Being concerned with the response of the internal control system to errors and required changes to prevent errors
  • Being concerned with the response of the internal control system to external stimuli. The internal control system must continually upgrade itself to deal with change
  • Acting as a training officer in internal control matters
  • Auditing the information given to management particularly interim accounts and management accounting reports
  • Taking a share of the external auditor’s responsibility in relation to the figures in the annual accounts and
  • Being concerned with compliance with external regulations such as those on the environment, financial services, related parties etc.

4.4.5 Essential Elements of Internal Audit

The essential elements of internal audit are as follows:

  1. Independence   Internal auditing is carried out by independent personnel. Internal auditors are employees of the firm and thus independence is not always easy to achieve.

     

  2. Staffing   The internal audit unit should be adequately staffed in terms of numbers, grades and experience.

     

  3. Relationships   Internal auditors should foster constructive working relationships and mutual understanding with management, external auditors, any review agencies and where appropriate with an audit committee. Mutual understanding is the goal.

     

  4. Due care   An internal auditor should behave much as an external auditor in terms of skill, care and judgment. He should be technically up to date and have personal standards of knowledge, honesty, probity and integrity much as an external auditor.

     

  5. Specific audit planning   On the basis of the objectives of the organisation and the objective of the internal audit of the organisation, the internal auditors should prepare the audit programme in order to cover the specified tasks assigned by the management.

     

  6. Systems control   The internal auditor must verify the operations of the system in much the same way as an external auditor, i.e. by investigation, recording, identification of controls and compliance testing of the controls.

     

  7. Evidence   The internal auditor must have similar standards for evidence as an external auditor. He must evaluate audit evidence in terms of sufficiency, relevance and reliability.

     

  8. Reporting   The internal auditor must produce timely, accurate and comprehensive reports to management on a regular basis.

Advantages

Internal audit provides the following advantages.

  1. Prevention of errors and frauds   It helps in the prevention of errors and frauds including misappropriation of cash and goods.

     

  2. Early detection of errors and frauds   It makes early detection of errors and frauds possible.

     

  3. Continuous review of internal control system   It undertakes continuous review of the internal control system and, as a result, it is capable of reporting irregularities for enabling corrective action in time.

     

  4. Assurance regarding accuracy of books and accounts   It checks books, records and accounts to ensure correct recording and their maintenance up to date.

     

  5. Preparation of interim accounts   It facilitates the preparation of interim accounts.

     

  6. Early completion of annual audit   It is of great use in early completion of annual statutory audit.

     

  7. Periodic physical verification   It carries out periodic physical verification of assets like cash, stock, investments and items of fixed assets.

     

  8. Assistance to the statutory auditor   It can render direct assistance to the statutory auditor by undertaking detailed checking of the accounting data and leave him free to concentrate on more important issues of principle, presentation and policy on accounting.

Disadvantages

Internal audit suffers from the following limitations.

  1. Extra cost   Internal audit system is not possible to be adopted by small organisations because the cost of running an internal audit department is very high.

     

  2. Biased opinion   Internal audit department employees are the paid-staff of the organisation. In most cases, they have to work according to the directions of the management. So it is not expected that they will provide unbiased opinion about the financial statements.

     

  3. Possibility of becoming ineffective   If the employees of the internal audit department are not efficient or if the internal audit is not conducted effectively, it will provide no assistance to the management.

     

  4. Possibility of distortion   If the management is interested to distort financial figures and if it is supported by internal audit department, the users of the financial statements will be totally misguided.

     

  5. Inefficient staff members   As there is no prescribed qualification for the appointment of internal auditors, less qualified persons may get appointment in the department. They will not be able to discharge their duties properly.

4.4.6 Area of Internal Audit

As per AAS-7, the scope and objectives of internal audit vary widely and are dependent upon the size and structure of the entity and the requirements of its management.

Normally, however, internal audit operates in one or more of the following areas:

  1. Review of accounting system and related internal control   The establishment of an adequate accounting system and related controls is the responsibility of the management, which demands proper attention on a continuous basis. The internal audit function is often assigned specific responsibility by the management for reviewing the accounting system and related accounting controls, monitoring their operation and suggesting improvements thereto.

     

  2. Examination for management of financial and operating information   This may include review of the means used to identify, measure, classify and report such information and specific inquiry into individual items including detailed testing of transactions, balances and procedures.

     

  3. Examination of the effectiveness of operations   Generally, the external auditor is interested in the results of such audit work only when it has an important bearing on the reliability of the financial records.

     

  4. Physical verification   The internal audit generally includes examination and verification of physical existence and condition of the tangible assets of the entity.

4.4.7 Distinction between Internal Audit and External Audit

On accounting matters, the internal and the external auditors operate mainly in the same field and they have a common interest in ascertaining that there is an effective system of internal control to present or detect errors and frauds and to ensure that it is operating satisfactorily and that an adequate accounting system exists to provide the information necessary for preparing true and fair financial statements. There are, however, some fundamental differences between the work of an internal auditor and that of an external auditor regarding the following:

1. Appointment

The internal auditor is appointed by the management, generally the Directors and is responsible to them.

The external or the statutory auditor is appointed according to the concerned statute. Generally, in case of company form of organisation, the auditors are appointed by the shareholders in the annual general meeting.

2. Scope

The extent of the work undertaken by the internal auditor is determined by the management.

The area of the work to be undertaken by the external auditor arises from the responsibilities placed on him by the governing statute.

3. Approach

The internal auditor’s approach is with a view to ensure that the accounting system is efficient, so that the accounting information presented to management throughout the period is accurate and discloses material facts.

The external auditor’s approach, however, is governed by his duty to satisfy himself that the accounts to be presented to the shareholders show a true and fair view of the profit or loss for the financial period and of the state of the company’s affairs at the end of that period.

4. Responsibility

The internal auditor’s responsibility is to the management. It follows that the internal auditor, being a servant of the company, does not have independence of status.

The external auditor is responsible directly to the shareholders. Unlike the internal auditors, he is a representative of the shareholders and has independence of status.

5. Objective

The objective of internal audit is to ensure that the laid down policies, procedures and other internal control functions are functioning as designed, whereas the objective of the external auditor is to express opinion on financial statements whether those statements are showing true and fair view.

6. Independence

External auditor is more independent in reporting than internal auditor.

Notwithstanding these important differences, the work of both the internal auditor and the external auditor, on accounting matters is carried out largely by similar means, such as

  • Examination of the system of internal check, for both soundness in principle and effectiveness in operation.
  • Examination and checking of accounting records and statements.
  • Verification of assets and liabilities.
  • Observation, inquiry, making of statistical comparisons and such other measures as may be judged necessary.

The wide experience of the external auditor may be of assistance to the internal auditor; while on the other hand the latter’s intimate acquaintance with the business concern may be of help to the external auditor. Co-operation in planning of the respective auditors may save unnecessary work, although the external auditor must always satisfy himself as to the work carried out by the internal auditor.

4.4.8 Relying Upon the Work of An Internal Auditor

The statement on AAS-7 describes the scope of reliance by the external auditor upon the work of an internal auditor. The purpose of this statement is to provide guidance as to the procedures, which should be applied by the external auditor in assessing the work of the internal auditor for the purpose of placing reliance upon that work. This statement states that while the external auditor has the sole responsibility of his report, however much of the work of the internal auditor may be useful to him in his examination of the financial statements. The responsibility of the external auditor is not reduced by any means because of the reliance placed on the work of the internal auditor.

As per AAS-7, the external auditor can use the work of the internal auditor after evaluation of the internal audit function. The external auditor should document his evaluation and conclusion in this respect while evaluating the work of internal audit function to determine the extent to which he can place reliance upon the following aspects considered:

  • Whether internal audit is undertaken by an outside agency or by an integral audit department within the entity itself.
  • Scope of internal audit and management action and internal audit report.
  • Technical compliance of the internal auditors, i.e. whether the internal auditors have the required experience and professional qualification.
  • Due professional care by the internal auditor, i.e. whether internal audit work appears to be properly planned, supervised, documented and if there is existence of adequate audit manuals.

This statement suggests the following features.

  1. The role of the internal audit function within an entity is determined by management and its prime objective differs from that of the external auditor, who is appointed to report independently on financial information.
  2. The external auditor should, as part of his audit, evaluate the internal audit function to the extent he considers that it will be relevant in determining the nature, timing and extent of his compliance and substantive procedures. Depending upon such evaluation, the external auditor may be able to adopt less extensive procedures than would otherwise be required.
  3. By its very nature, the internal audit function cannot be expected to have the same degree of independence as is essential when the external auditor expresses his opinion on the financial information. The report of the external auditor is his sole responsibility, and that responsibility is not by any means reduced because of the reliance he places on the internal auditor’s work.

Where internal audit is carried out, it is for the external auditor to decide, consistently with his statutory responsibilities, whether and to what extent, he can rely on the work of the internal auditor in order to reduce the extent of his own examination of details.

His decision in this matter will depend upon his judgment on the facts of each case, having regard in particular to the following:

  1. The extent and efficiency of the internal audit; i.e. in order to assess these matters, the external auditor should examine the internal audit programmes, working papers and reports and should make such tests as he thinks fit for the work done by the internal auditor.
  2. The experience and qualifications of the internal auditor and his staff member and the character of their reports and also the action taken by the management on the basis of the report.
  3. The authority vested in the internal auditor and the level of management to which he is directly responsible.

However, the statutory auditor can not in any circumstance divest himself of the responsibilities laid on him by the statute. In other words, if the external auditor has curtailed the extent of his checking, putting reliance on the work of the internal auditor, the responsibility for any deficiency in that financial statements that may remain undetected will be of the statutory auditor, he cannot plead that he has relied on the work done by the internal auditor.

4.5 AUDITOR’S INDEPENDENCE

By the term ‘auditor’s independence’ we mean that the judgment of the auditor is not subordinated to the wishes or directions of any person who might have engaged him or to his own self-interest.

It is not possible to define the term ‘independence’ in a precise manner. Basically, it is a condition of mind, and personal in character. However, professional conduct of the auditors support auditor’s independence. Auditors, by their function of reporting on financial statements, lend creditability to those statements. Parties interested in such statements put implicit faith and trust on those statements based on the opinion of the auditor. So, for the auditors, independence has a special meaning and significance. Unbiased audit can be carried out only when the auditor is able to resist all pulls and pressures. The auditor should not only be independent in fact, but also must appear to be so; otherwise his report would be suspected and would lack creditability.

4.5.1 Advantages of Independent Audit

The principal advantage of an independent audit lies in the society being able to get an informed, objective and unbiased opinion on the financial statements of an organisation which is used in making significant economic decisions by interested segments of the society, i.e. shareholders, creditors, bankers etc. It is to be noted that only the auditor is in a position to examine the accounts and transactions of an organisation with a view to form an opinion. His report is, therefore, the only real safeguard available to the various parties interested in the financial affairs of the organisation.

4.5.2 Provisions for Safeguarding Independent Auditors

Several provisions have been included in the Companies Act with the objective of securing independence of the auditor. In general, these provisions endow the auditor with certain statutory rights, define certain relationships that may entail a compromise in maintaining independence, requiring that normally the auditor would be appointed in the general body meeting by the shareholders and making the removal of auditor difficult by laying down procedures under the Companies Act. The rights of the auditor are statutorily defined in several sections and they cannot be curtailed or limited by the management or even by the shareholders.

The management has no authority to terminate the appointment of any auditor. The auditor when appointed shall be entitled to hold office till the conclusion of the next annual general meeting. Though mid-term removal of the auditor is not ruled out, it can be accomplished only by the shareholders in the general meeting and with previous approval of the central government. It is also worth mentioning that the duties cast on the auditor can not be diluted by any agreement between the organisation and the auditor. There can thus be no temptation for the auditor to do less than what the law requires.

4.6 DISTINCTION BETWEEN INTERNAL CONTROL AND INTERNAL AUDIT

A system of internal control consists of all the measures employed by an organisation for the purposes of

  1. safeguarding its resources against waste, fraud and inefficiency,
  2. promoting accuracy and reliability in accounting and operational data,
  3. encouraging and measuring compliance with the organisational policy, and
  4. judging the efficiency of operations in all the divisions of the business.

It is concerned with the plan of the organisation, allocation of duties among the employees and authorising, recording and custody procedures to ensure operation of internal check on the one hand and managerial supervision and review on the other. Managerial supervision and review is accomplished by the sub-system of internal auditing which is a part of the total internal control system.

Though internal audit is a part of the internal control system, it is indeed a significant part as with the introduction of internal audit system, the performance and compliance with management policies and practices are ascertained on a continuous and timely basis and brought to the notice of management. Internal audit also reviews the overall internal control system, its efficiency or redundancy, though it is itself a part of that overall system. In other words, internal auditing, though a part of the total internal control system, is also a significant complement of the system, reviews the system and checks its operations so that the management can be given up-to-date information on the effectiveness of control and the underlying operations.

4.7 DISTINCTION BETWEEN INTERNAL CHECK, INTERNAL AUDIT AND INTERNAL CONTROL

Internal check has been defined by the Institute of Chartered Accountants in England and Wales, as the “checks on day-to-day transactions which operate continuously as part of the routine system whereby the work of one person is proved independently or complementary to the work of another, the object being the prevention or earlier detection of error or fraud.” The internal check in accounting system implies the organisation of the system of book-keeping and arrangement of staff duties in such a manner that no one person can completely carry through a transaction, and record every aspect thereof.

Internal audit has been defined by the Institute of Internal Auditors, USA recently of as an “independent, objective assurance and consulting activity designed to add value and improve an organisations, operations. It helps an organisation accomplish its objectives by bringing a systematic disciplined approach to evaluate and improve the effectiveness of risk management, control and governance process.” Traditionally internal auditing was considered to be restricted to the examination of the books of accounts of the organisation with a view to ascertaining whether they correctly record the transaction. In fact, a good internal control system should have internal audit as an integral part. The modern concept of internal auditing as given in the aforesaid definition shows that internal auditing has moved significantly ahead by shouldering greater responsibilities to become one of the important management control devices.

It can be seen from the above definitions of both internal check and internal audit that they are parts of overall control system. Internal check operates as a built-in device as far as staff organisation and job allocation aspects of the control system are concerned. On the other hand, the adequacy and operations of internal control on a regular basis is to be reviewed by the management through internal audit system to ensure that all significant controls are operating effectively. Thus, internal check is merely an arrangement of bookkeeping and clerical duties, but internal audit involves evaluating the quality and operation of the various controls.

Inter-relationship between internal control, internal check and internal audit can be described with the help of the following diagram:

Case Study 1

Fast Move Ltd. is a listed company in the food processing industry. They have 10 factory sites and 2,500 workers. They have grown very rapidly in recent years under the direction of Sidharth, who is a very dynamic character. He tries to operate on the lowest possible costs and sees internal control as himself and his factory managers. The company has recently moved into the production of mass produced South-Indian foods and gambled that they will grab a large market share. They have an audit committee (not liked by Sidharth) but no internal audit department.

Discussion

  1. What advantages might accrue to the company if they set up an internal audit department?
  2. How might the auditors approach the audit?
  3. What are the specific duties imposed on the auditor regarding internal control and internal audit?

Case Study 2

Skylark Real Estate Ltd. is a company offering estate agency services to the public through a network of branches all over the country. The company has some 300 staff in all. The board consists of six people, a part-time chairman, a chief executive, two other full time executives and two representatives of the owners. The company is jointly owned by a foreign bank and the City Property Group. The company has an internal audit department consisting of Sanjeev who is a young Chartered Accountant and Rajeev who is an accounting expert. They also have a secretary, Ritwika. They report their activities monthly in detail to the board and to the audit committees of the foreign bank and the City Property Group.

Discussion

  1. What work would the internal audit department do?
  2. In what ways may the external auditors place reliance on their work?
  3. Draw up a check list which the external auditor could use to assess the internal auditors as potentially being capable of producing work on which the external auditors may rely.
POINTS TO PONDER
  • Internal control refers to the various methods and procedures adopted for the control of production, distribution and the whole system (financial and non-financial) of the enterprise.
  • Basic elements of internal control include financial and other organisational plans, competent personnel, division of work, separation of operational responsibility for recording keeping, separation of the custody of assets from accounting, authorisation and managerial supervision and review.
  • Internal control can be categorised as organisation, segregation of duties, physical, authorisation and approval, arithmetical and accounting, personnel, supervision and management.
  • Advantages of internal control include identification of defects, flexibility, time saving, lesser risk of omission and provision for training facility.
  • Disadvantages of internal control include chances of human error, costly, ignorance of unusual activity, collusion, abuse of responsibility and rigidity.
  • Evaluation of internal controls is fundamental to an audit. On the basis of evaluation on the effectiveness of the internal control system, the external auditor will decide the extent or degree of his reliance on the functioning on the internal control system.
  • Internal control questionnaire is basically a comprehensive list of questions, covering every aspect of the client’s system, the answers to which will enable the auditor to assess the internal controls in operation.
  • Internal check is arrangement of the duties of the staff members of the accounting functions in such a way that the work performed by a person is automatically checked by another.
  • Factors to be considered in framing a system of internal check include work assignment, rotation of employees, compulsory leave, supervision of inter-related jobs, uses of mechanical devices, periodical review, responsibility, safeguards, supervision and reliance.
  • Objectives of internal check include assigning responsibility, minimising error or fraud, detecting error or fraud, reducing clerical mistakes, enhancing work efficiency, obtaining confirmation, reducing burden of work, exercising moral pressure, ensuring reliability and obtaining supervision advantages.
  • Advantages of internal check can be viewed from three different viewpoints. From business point of view, the advantages include proper allocation of work, control device, speedy work, increase in efficiency and skill, easy preparation of final accounts and creation of moral check. From the viewpoint of the owners, the advantages include reliability on accounts, orientation of accounting and economical operation. From the viewpoint of the auditor, the advantages include facilitation of audit work and attention to other important matters.
  • Shortcomings of internal check include monotony, carelessness, collusion, limited application, dependence and possibility of disorder.
  • The auditor is expected to apply proper judgement with reasonable care and skill to appraise the internal check system. He has to determine to what extent he would depend on internal check system, as internal check system does not reduce the liability of the auditor.
  • Internal audit refers to an independent appraisal of activity within an organisation for the review of accounting, financial and other business practices. It is a separate part of internal control system.
  • Basic principles of establishing internal audit in a business concern include independent status, scope of audit, clear objectives, formation of the department, time-bound programme, internal audit report, follow-up action and performance of executive action.
  • Objectives behind establishment of internal audit department include accuracy in accounts, adoption of standard accounting practices, proper authority on assets, confirmation of liabilities, analysis of internal control system, prevention and detection of fraud, provision for new ideas, review of the operation of the internal control system, special investigation and review of organisational activities.
  • Internal audit performs a number of functions including appraisal function, service to the organisation and other duties.
  • Essential elements of internal audit include independence, staffing, relationship, due care, specific audit planning, systems control, evidence and reporting.
  • Prevention of errors and frauds, early detection of errors and frauds, continuous review of internal control system, assurance regarding accuracy of books and accounts, preparation of interim accounts, early completion of annual audit, periodic physical verification and assistance to the statutory auditor are the advantages of internal audit system.
  • Disadvantages of internal audit include extra cost, biased opinion, possibility of becoming ineffective, possibility of distortion and inefficient staff members.
  • Area of internal audit covers review of accounting system and related internal control, examination for management of financial and operating information, examination of the effectiveness of operations and physical verification.
  • External audit and internal audit can be differentiated with respect to appointment, scope, approach, responsibility, objectives and independence.
  • The statutory auditor can use the work of the internal auditor after evaluation of the internal function, but the responsibility for any deficiency will be of the statutory auditor and he cannot plead that he has relied on the work done by the internal auditor.
  • Auditor’s independence means the judgement of the auditor is not subordinated to the wishes or directions of any person who might have engaged him or to his self-interest. The principal advantage of an independent audit lies in the society being able to get an informed, objective and unbiased opinion on the financial statements of an organisation.
REVIEW QUESTIONS

Short-answer Questions

  1. Distinguish between internal control system and internal check system.
  2. What is internal control questionnaire?
  3. Should the statutory auditor examine the accounts already checked by the internal auditor?
  4. To what extent is the internal auditor responsible for internal control?
  5. How does the internal check system affect the work of an external auditor?
  6. What are the precautions to be taken in the application of internal check system?
  7. State briefly the matters to be included in the auditor’s report in respect of the internal audit system of a large manufacturing company?
  8. What are the objectives of internal audit?

Essay-type Questions

  1. What do you mean by the term ‘internal control’? What are the important features of a good system of internal control?
  2. What is internal audit? Distinguish between internal control and internal audit? “The modern concept of internal audit envisages scope of internal audit much beyond financial audit”. Explain.
  3.  
    1. Distinguish between internal audit and statutory audit.
    2. Can the statutory auditor rely upon the internal audit in carrying out his function as a statutory auditor?
  4. Suggest a set of rules you would recommend for the internal control over the purchases of raw materials and stores of a large manufacturing concern.
  5. Draft a form of questionnaire, that you would use to determine the effectiveness of the client’s internal control over payrolls.
  6.  
    1. Distinguish between internal control, internal check and internal audit.
    2. Discuss the general considerations in framing a system of internal control in respect of purchase of goods.
  7. Comment on the following statements:
    1. “The statutory auditor is entitled to rely on the internal auditor.”
    2. “The statutory auditor should test internal control system before relying on the same.”
  8.  
    1. Discuss the objectives of internal control system.
    2. Discuss the advantages and limitations of internal control system.
  9. “In a good system of internal check, the work of one is checked indirectly by the work of another” Explain and discuss this statement with examples.
  10. What system of internal check would you recommend for a manufacturing concern to prevent fraud in connection with credit purchase of raw materials.