Benefits of Internal Control to the entity

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Fundamentals of Auditing ACC 311

Lesson 17

DOCUMENTING THE INTERNAL CONTROL SYSTEM

Benefits of Internal Control to the entity

Based on our previous studies we can now identify the following principal benefits that may arise for an

entity from a sound system of internal control:

Assurance that all transactions are completely and accurately processed.

Confidence that only authorized transactions takes place.

Assurance that adequate documentation supporting transactions is created and retained.

Assurance that the company's assets and liabilities are correctly stated, in order for them to

make informed decisions on the operations of the business.

Minimization of the risk of fraud and misappropriation of assets.

Benefits of Internal Control to the auditor

Of course, if the audit client benefits from a sound system of internal control, it is likely that the auditor will

also be benefited. All of the above stated benefits help to promote a situation where the financial statements

present a true and fair view. In simple terms, a good system of internal control will make life easier for the

auditor.

Auditor's work on the Internal Control

International standards on auditing emphasize the importance of internal control to the auditor by stating

that auditor should:

Obtain an understanding of the accounting and internal control system sufficient to plan the

audit and develop an effective audit approach, and

Use professional judgment to assess the components of audit risk and to design audit

procedures to ensure it is reduced to an acceptably low level.

At an early stage in their work auditors will have to decide the extent to which they wish to place reliance on

the internal controls of the enterprise. As the audit proceeds, that decision will be kept under review and,

depending on the results of their examination, they may decide to place more or less reliance on these

controls.

Categories of Internal Control

These are often summarized by using the mnemonic SOAP MAPS as follows:

a) Supervision

b) Organization

c) Arithmetic and Accounting

d) Physical

e) Management and Monitoring

f) Authorization

g) Personnel

h) Segregation of duties

a) Supervision

There should be adequate supervision of work to ensure that controls are being complied with.

Possible application: a supervisor or manager reviews and checks the work of a subordinate.

b) Organization

Enterprises should have a formal, documented organization structure with clear lines of

responsibility.

Possible application: lines of authority within an organization make it clear which individuals are responsible

for decisions and transactions

c) Arithmetic and Accounting

The company should ensure that there are adequate controls to ensure the completeness and

accuracy of its financial records.

Fundamentals of Auditing ACC 311

Possible application: standard accounting procedures such as the use of control accounts, reconciliation

procedures and the performance of arithmetic checks on accounting records.

d) Physical

There should be adequate physical control to ensure the security and safekeeping of its assets such

as plant and machinery, valuable inventory items and cash.

Possible application: banking cash immediately, controlling access to inventory areas; electronic tagging of

inventory and portable non-current assets.

e) Management and Monitoring

There should be sufficient controls in existence to ensure management can effectively control the

business operations.

Possible application: the use of budgeting and standard costing systems; the establishment of an internal

audit department

f) Authorization

All transactions should be authorized.

Possible application: authorization of purchases, cash and bank payments, sale of non-current assets, sales

to customers on credit, bad debt write offs.

g) Personnel

Employees should be appropriately qualified and of suitable caliber to perform the required tasks.

Possible application: recruiting the right people for the job; training them effectively, motivating and

rewarding employees in an appropriate way.

h) Segregation of duties

There should be an appropriate division of responsibilities to reduce the opportunity for fraud and

manipulation.

This is a fundamental control procedure designed to ensure that one person does not have sole

charge of a transaction from beginning till end. Perfect segregation of duties exists where each of

the main stages in a transaction are under the control of a different person.

Possible application:

Consider an inventory purchasing system in a manufacturing company:

Stage

Documentation

Responsibility

Initiation

Stores requisition

Stores keeper

Authorization

Purchase order

Purchasing officer

Custody

Goods received note

Receiving officer

Recording

Invoice

Account department

Documenting the system

Documenting the system is an extremely important stage in the audit;

Auditing standards state that in planning the audit, auditors should obtain and document an understanding

of the accounting system and control environment sufficient to determine their audit approach.

The various methods of ascertaining and recording the system may be summarized as follows:

1. Organization chart

2. Narrative notes

3 Flowcharts

4 Internal control questionnaires (ICQs)

5 Internal control evaluation checklists (ICEC)

Fundamentals of Auditing ACC 311

Organization Chart

Managing Director

Production

Sales

Finance

Director

Distribution

Advertising

Manager

Manger

Chief

Manager

Production Factory

Purchases

Accountant

Accounts

Planning

Manager

Controller

Narrative Notes

This is a simple and apparently convenient way of describing systems. Having ascertained the system, the

auditor draws up a narrative description of it for the audit files. An example might be:

Sales invoices are prepared by Mr._____ They are checked by Mr. _____ and then passed to Mr. _____ for

recording in the customer's account in the sales ledger etc.

Shortcomings of the method:

1. Notes can take up a disproportionate amount of space

2. Notes may be difficult to interpret

3. What happens it personnel change?

Flowcharts

This is becoming an increasingly widely used technique for recording accounting systems in audit files.

A flowchart is a diagrammatical representation of an accounting system.

A good flowchart will be supplemented with narrative.

Flowcharts have the following advantages:

(i)

They portray the flow of documents through the system and enable the auditor to relate those

movements with procedures and checks carried out as part of that system.

(ii)

They show the movement of documents in such a way that, when properly prepared, the

sources and destinations of all documents will be clear.

(iii)

They help to highlight weaknesses in the control of the business.

(iv)

They enable audit tests to be clearly related to weaknesses in the accounting system.

Standard symbols are used to represent documents, operations and checks carried out.

Flow lines are used to join up the symbols and represent the movement of documents.

Dotted lines are used to represent the flow of information between documents.

Essentials of flowchart

Internal control evaluation flowcharts must highlight the following:

(a) the sequence of operations happening to each document (e.g. authorization, checking, matching, filing)

(b) the segregation of staff duties and who is responsible for each operation.

Fundamentals of Auditing ACC 311

Symbols used in manual systems flowcharts

A document

A multi-part set of documents

Pre-numbered document

A book of account

An operation performed on a document

A check performed on a document

Filing a book or document

Document flow

Information flow

Connector with another page/flow-line

Fundamentals of Auditing ACC 311

Flowchart of purchases

Narratives:

1 Requisition note raised when goods

are at a pre-set re-order level. Order

quantity is pre-determined by use of a

copy of the previous purchase order.

2 Signed by store manager.

3 Buyer checks authorization.

4 Purchase order set prepared.

8 P02 filed temporarily to act as a check

on overdue deliveries.

10 P04 and P05 are filed until goods are

received.

11 Weekly check on overdue deliveries.

12 Goods checked to PO to ensure they

are in agreement.

13 If not damaged, goods are accepted

and a goods received note set is raised.

Where quantity received is below order a

shortage memo set is also raised and a

note made on the purchase order.

14 P05 is sent back to the warehouse to

act as the next requisition note.

Commentary on the above flowchart

(a) All operations and checks are positioned on vertical lines within a particular department.

(b) Horizontal lines show the movement of a document between departments.

note/day books/payables ledger/cash book etc. The

flow-lines at the bottom of the page would continue to page 2 of the flowchart.

(d) Note that the narrative to the flowchart does not deal with all of the operation numbers since some

should be self-explanatory e.g. operation 9 represents the

numerical filing of P03 in the buying department.

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