INTERNAL CONTROL

1. MEANING OF INTERNAL CONTROL

The term “Internal Control System” means all the policies and procedures (Internal Controls)
adopted by the management of an entity to assist in achieving management’s objective of
ensuring, as practicable, the orderly and efficient conduct of its business, including adherence to
management policies the safeguarding of assets, the prevention and detection of fraud and
error, the accuracy and completeness of the accounting records, and the timely preparation of
reliable financial information. The internal control system extends beyond those matters which
relate directly to the function of the accounting system and comprises.
Factors reflected in the control environment include.
 The function of the board of directors and its committees.
 Management’s philosophy and operating style.
 The entity’s organizational structure and methods of assigning the authority and
responsibility.
 Management’s control system including the internal audit function personnel policies
and procedures and segregation of duties.

Specific control procedures include:

 Reporting, reviewing and approving reconciliations.

 Checking the arithmetical accuracy of the records.
 Controlling applications and environment of computer information systems, for example
by establishing controls over.
o Changes to computer programmes
o Access to data files.
 Maintaining and reviewing control accounts and trail balances.
 Approving and controlling of documents.
 Comparing internal data with external sources of information
 Comparing the results of cash security and inventory accounts with accounting records.

2. CATEGORIES OF INTERNAL CONTROL

Internal control can be divided into two categories
a. Financial Control
b. Management Control

a. Financial Control
i. Budgetary Control
ii. Legitimacy of income and expenditures
iii. Accounting controls
b. Management or Operational Control
i. Objectives
ii. Organization Procedures.
iii. Organizational Structure.
iv. Management Information
v. Proper Supervision.
vi. Review of operational efficiency.

3. THE NEED FOR INTERNAL CONTROL

In case of companies the volume of work is so great and of varied nature that it is beyond the
capacity and control of any one individual. In this circumstance it becomes essential to delegate
responsibility.
In order to carry on the business of the company in an orderly manner safeguard its assets and
secure as far as possible the accuracy and reliability of its records.

4. PRINCIPLES OF INTERNAL CONTROL

I. Financial and accounting operations must be separated i.e. the handing of cash and the
recording of the movement thereof should be done by different persons.
II. Responsibility for the performance of the job must be clearly stated so that there may be no
room for doubt or confusion subsequently.
III. Too much confidence should not be pinned in one individual. Nearly all frauds have been
committed by trusted officials or employees. It is interesting to note that frauds have
occurred owing to their being trusted.
IV. Rotation principle relating to transfer of an employee from one job to another should be
inflexible guiding rule. This is an effective safeguard against collusion and is recognized as an
important canon of sound organization.
V. Mechanization of the work wherever feasible and practicable should be resorted to
mechanical devices such as cash register, recording time clocks, calculation machines etc.
should be introduced.
VI. The work should be so arranged that work done by one employee should be promptly
checked by another independent employee. Such continuous and constant checking goods,
moral control and the errors and the fraud cannot go undetected.
VII. The arrangement of the work should be in such a manner that written record fo the part
played by each employee should be maintained and the work should pass through several
hands in a well defined manner.
VIII. Clear and well defined rules should be laid down and practically followed relating to dealing
of the cash ordering, receiving and issuing goods etc. instructions should be in writing in the
form of accounting manuals.
IX. Although not a substitute for protective for protective financial internal control yet double
entry system of accounting must be used.
 Based on the practical operational aspect of the problem, personnel must be segregated with the
following functions.

i. Those initiating or authorizing the transactions.

ii. Those having responsibility for asset liability expense or revenue resulting from the transactions.

Some of the examples of internal controls are as under.

i. Physical Clock cards, cash register, etc.

ii. Mechanical Invoice typewriter, tabulating and computer machines.
iii. Theoretical Work of one employee is to be checked by another, cashier abstaining from
making entries in the ledgers etc.

5. REVIE AND RELIANCE ON ITNERNAL CONTRL BY THE AUDITOR

Before starting the audit, the auditor should review the system of internal control for the following
considerations.

1. To examine the weaknesses of system, if any.

2. To consider the proposition of introducing test check to be performed during the course of audit
3. Based upon above (1) & (2) determine exactly the work to be performed so as to enable the
auditor to express his opinion on the given set of accounts.

The effectiveness of the system in practice should be tested to form an opinion that whatever
existed on the paper did exist in practical aspect also. A proper and effective system of internal
controls offers advantages such as saving of time for the auditor, reduction in cost of conducting
audit and assurance to auditor of the reliability of the financial accounts. The review of the system
of financial internal control would involve either oral questioning or use of written questionnaire for
the audit of each aspect of business.

It is advisable the at the auditor should obtain a statement in writing abridging the details of internal
controls in practice. It is interesting to note that the existence of a good internal control reduces to a
great extent the work of the auditor, but does not reduce his liability. To what extent should an
auditor depend upon the system will depend upon the circumstances of each particular case and the
efficiency of the audit will depend upon the skill, tact, experience and above all the judgment of the
auditor.

6. CONDIDERING THE WORKOF INTERNAL AUDITING.

i. The purpose of this international Standard on Auditing (ISA) is to establish standards and provide
guidance to external auditors in considering the work of internal auditing. This ISA does not deal
with instances when personnel from internal auditing assist the external auditor in carrying out
external audit procedure.
ii. The external auditor should consider the activities of Internal Auditing and their effect, if any, on
external audit procedures.
 iii. While the external auditor has sole responsibility for the audit opinion expressed and for
determining the nature timing and extent of external audit procedures, certain parts of internal
auditing work may be useful to external auditor.
iv. SCOPE AND OBJECTIVES OF INTERNAL AUDITING
Ordinarily, internal auditing activities include one or more of the following.
 Monitoring of internal control
 Examination of financial and operating information.
 Review of the economy, efficiency and effectiveness of operations including non financial
controls of an entity.
 Review of compliance with law, regulations and other external requirements.
v. RELATION BETWEEN INTERNAL AUDITING AND EXTERNAL AUDITOR
The role of internal auditing is determining by management and its objective differs from those of
the external auditor who is appointed to report independently on the financial statement. The
internal audit function’s objective varies according to management’s requirements. The external
auditor’s primary concern is whether the financial statements are free of material mis-statement.
UDERSTANDING AND PRELIMINARY ASSESSMENT OF INTERNAL AUDITING
vi. The external auditor should obtain a sufficient understanding of internal audit activities to identify
and assess the risk of maternal misstatement of the financial statements and to design and perform
further audit procedures.
vii. Effective internal auditing will often allow a modification in the nature and timing and a reduction in
the extent of audit procedures performed by the external auditor but cannot eliminate them
entirely.
viii. When obtaining an understanding and performing an assessment of the internal audit function, the
important criteria are following.
a. Organizational status: specific status of internal auditing in the entity and the effect this has on its
ability to be objective.
b. Scope of function: the nature and extent of internal auditing assignments performed. The external
auditors would also need to consider whether management acts on internal audit recommendations
and how this is evidenced.
c. Technical competence.
ix. EVALUATING WORK OF INTERNAL AUDITING.
The evaluation of specific work of internal auditing involves consideration of the adequacy of the
scope of work and related programs and whether the assessment of the internal auditing remains
appropriate.
7. SYSTEMS OF INTERNAL CONTROL
A. SMALL CONCERNS
a. Correspondence
b. Remittances and deposits.
c. Payment authorization.
d. Wages and salaries.
e. Goods
 B. MANUFACTURING CONCERNS
a. Access to ledgers.
b. Correspondence
c. Remittances
d. Deposit
e. Printed form
f. Cash sales.
g. Payment authorizations
h. Wages
i. Petty cash
j. Purchases
k. Credit notes
l. Statement of account
m. Control accounts
n. Mechanical appliances
o. Cash receipts
p. Cash payments
q. Petty cash transaction.
r. Purchases
s. Sales
t. Postal sales
u. Sales over the counter
v. Stores

8. EVALUATION OF INTERNAL ACCOUNTING CONTROL

FIRST PHASE OF EVALUATION

In this connection the auditor should obtain understanding of

1) The control environment and

2) Flow transaction through accounting system.

The control system consists of organizational structure of the client, methods to communicate authority
and responsibility financial reports used for planning and control purpose competence of personnel and
administrative method.

SECOND PHASE OF EVALUATION

This includes a detailed review of internal accounting control system. The purpose of this review is
to understand the adequacy of the controls and their operation. In order to understand the internal
accounting system, the auditor generally obtains information from different sources such as reviews
of accounting manuals interviews with client personnel, review of job descriptions and analysis of
the organization chart. After getting this information, the auditor often performs a walk though of
the system.

i. Narrative
ii. Flow chart
iii. Walk through
iv. Questionnaire