Auditing chapter 2 slides for final year bcom students

Auditing chapter 2 slides for final year bcom students

1. Principles and Practice of Auditing

2. Unit -2 Internal Control

3. Internal Control Meaning: Internal control system is defined by ISA as follows: “The internal control system means all policies and procedures ( internal control) adopted by the management of entity to assist in achieving management objective of ensuring as far as practicable the orderly and efficient conduct of its business , including : Adherence to management policies Safeguarding of assets Prevention and detection of fraud and error Accuracy and completeness of accounting records Timely preparation of financial statements “Internal Control is best regarded as indicating the whole system of controls, financial and otherwise established by the management in the conduct of a business, including internal check, internal audit and other forms of control,”

4. Why to have internal control? Purposes A) From Client’s point of view Providing reliable data Safeguarding assets and records To promote operational efficiency To encourage adherence to prescribed policies B) From the Auditor’s point of view To study and evaluation of the client’s system of internal control is important to auditors. The auditors must have a through understanding of the system to obtain the adequate understanding the system must also be tested. There are two ways in which the evaluation of the client’s system of internal control is used i ) To determine whether an audit is possible ii) To determine the scope of audit.

5. Principles of Internal control: Competent and trustworthy personnel Records, financial and other organizational plans Segregation of duties i ) Separation of operational responsibility from record-keeping responsibility ii) Separation of the custody of assets from accounting 4. Supervision 5. Authorization-written (General and specific) 6. Sound practices 7. Internal audit 8. Arithmetic and Accounting Controls

6. Scope of Internal control General financial control Cash Control Control over trading transactions Control over employees remuneration Capital Expenditure control Others like Maintenance of staff relationships, Stock maintenance, Control over the investments. Limitations of Internal Control Operation of the internal control system involves expenditure of time and money. Unusual and irregular transactions may be overlooked by the internal control system. The possibility for human error may weaken the internal control Possible collusion between persons operating the internal control and the employees of the client/outside parties may render the controls ineffective The possibility that a person responsible for exercising control could abuse his authority Manipulation by the management may defeat the objectives of internal control.

7. INTERNAL CHECK Meaning : Internal check means practically a continuous internal audit carried on by the staff itself, by means of which the work of each individual is independently checked by other members of the staff. In other words Internal check is the arrangement of the accounting system of a business allocated that no one person is left in sole management of any one duty, and the work of one person is checked automatically by another so that errors and frauds are quickly detected and prevented.

8. Essentials Elements of Internal Check: The work is divided among the staff members in such a way that all the duties are distributed among staff members The work is assigned to the staff members according to their qualifications, experience ability etc., No one person is allowed to do any single task from the beginning to the end. The work of each staff member, though independent, is complementary to the work of another. Each staff member is held liable for any error in the task assigned The work done by one staff member is checked independently and automatically by another. There is no duplication of work in the process of independent checking Checking is carried out continuously as a part of the routine system.

9. Objectives of Internal check: To exercise moral pressure over staff. To ensure that the accounting system produces reliable and adequate information's. To provide protection to the resources of the business against fraud, carelessness and inefficiency To distribute the work in such a manner that no business transactions is left unrecorded. To allocate duties and responsibilities of each clerk in such a way that he may be held responsible for particular fraud or error. To minimize the chances of errors, frauds or irregularities in the business. To increase the efficiency of clerks because the allocation of duties is based on the principle of division of labour . To detect errors and frauds easily if it is committed, because in an efficient internal check system, there is a provision for independent checking.

10. Essential characteristics/Principles of a good system of internal check Responsibility Completion Rotation of employees Automatic check Reliance Safeguards Supervision Formal sanction Periodical review

11. Advantages of internal check 1. For the Business a) Proper division of work b) Detection of errors and frauds c) Increased efficiency coupled with economy d) Moral check 2. For the Auditor a) Quick preparation of final accounts b) Convenience of auditor 3. For the Owner a) Accuracy or the accounts can be relied upon b) Increase in profits

12. Disadvantage of internal checks Costly for small business Quality is sacrificed for promptness Carelessness among high officials Disorder in the working of a business Risky for an auditor

13. Internal Check as regard to wage payment Objectives: 1. To avoid inclusion of dummy workers in the list of workers. 2. To avoid incorrect time or piece work records 3. To avoid fraudulent manipulation of wage-sheets and misappropriation of money etc. 1. Maintenance of Wage Records Time Records i ) The time recording clock ii) Brass token iii) Attendance cards 2. Piece-work Records 3. Overtime records 4. Pass-out Records

14. Internal Check as regard to wage payments 2. Preparation of wage sheet: The work of preparation of wage sheets should be done by a separate department. This work should be done at least by five clerks, so that irregularities may be minimized. Two clerks should examine the time and piece wage records, overtime records and other statements received from the foreman. Third clerk is to prepare individual employee statement Fourth clerk is to check the calculations and deduct the permissible amount Fifth clerk is to check the whole work thoroughly. All these clerks should initial the wage slips before these are signed by some responsible officer.

15. Internal Check as regard to wage payments 3.Payment of Wages: The cashier should with draw the net amount as shown in the wage sheets. The payment of wages must be made by a person, who is in no way concerned with the preparation of wage sheets. Each worker, who is to receive the wages should be present at the time of disbursements. The foreman of each department should be present at the time if payment to identify the workers of his section. The signatures of the workers must be obtained, when they receive the amount. Special arrangements should be made to pay to the absentee workers. A list of unpaid workers should be prepared by the cashier and foreman of each department. The officer employing casual workers should not be connected with the payment of wages. Casual workers should be paid wages on a different day. Surprise visit of a senior official while distribution will be effective measure of control.

16. Internal Check as regard to Cash Sales INTERNAL CHECK WITH REGARD TO CASH The risk of misappropriation of cash needs no emphasis. The chances of fraud are numerous in cash transactions. For example, receipts may not be entered in the cash-book: records of cash received may be understated by preparing duplicate receipt for amounts less than the original. Cash sales may be treated as credit sales charging the amount to fictitious debtors, etc. The following are the points that should be taken into consideration while devising a good and proper system of internal checks for cash transactions . CASH SALES: Cash Sales are of three types: a. Sales at Counter / Counter Sales b. Sales by travelling Salesmen. c. Postal sales.

17. Internal Check as regard to Cash Sales 1)SALES AT COUNTER / COUNTER SALES: The following procedure may be of great use in regard to cash sales: i ) A specific number, name or work may be allotted to every salesman. ii) Every salesman is supplied with a separate book containing blank copies of cash memo. iii) Cash memos should be printed in numerical sequence. iv) Cash memos are printed in different colours for salesman at different counters. v) When the sales man sells goods to a customer he prepares four copies of the Cash Memo. These copies are checked by the senior clerk. vi) Three copies of the cash memo are handed over to the customer and the fourth is retained by the salesman. vii) The customer should hand over three copies of the cash memos to the cashier, who alters collecting the amounts and recording it in his cash register, returns two copies to the customer duly stamp marked “cash paid”. viii) So the cashier collects the amount and records it in his cash register.

18. Internal Check as regard to Cash Sales ix ) The customer should present two copies of the cash memos at the counter where the goods purchased by him are to be delivered. x) Here the customer will get the goods purchased by him are to be delivered to him. xi) The Clerk, at the delivery counter, checks the sales and delivers the goods to the customer and also keeps one copy of the cash memos. xii) In big business houses, the customer’s copy of the cash memo may be checked by the security staff before the customer is allowed to check out of the place. xiii) At the end of the day, each counter salesman, cashier and the delivery counter clerk should prepare summaries of Cash Sales. xiv) The cash sales summary prepared by the cashier should be verified with the cash sales summary of each salesman and the delivery counter clerk. xv) The differences if any should be immediately enquired into. xvi) If the summaries tally, accounts are certified as correct. Then it is sent to the General Manager and another copy is sent to accounts department. xvii) Daily cash receipts should be deposited into the bank on the same day.

19. Internal Check as regard to Cash Sales 2) Sales by Travelling Salesmen: In big business houses, generally Travelling salesmen are employed to push sales and to collect debts. These Salesmen collect debts from old customers and accept advances for new ones. Ordinarily debtors will be asked to send the remittances by post and not to hand over the cash to any representative of the enterprise. But in exceptional circumstances travelling Salesmen may be permitted to collect cash from the debtors . So the following precautions must be taken . i . Travelling salesmen should be issued with pre-numbered, rough receipt books. ii. Final receipt against receipt of cash by travelling salesman should be issued either from the branch or head office to which the salesman is attached.

20. Internal Check as regard to Cash Sales iii . Customers should be asked to contact the head office or branch office if the final receipt is not mailed to them within a stipulated period. iv . Travelling salesmen should be instructed to remit the entire cash collected by them to the head office or branch office to which they are attached, without making any deduction towards salary or commission payable to them. v . Head office or branch office should regularly send the statement of accounts to keep them informed of the latest position as to their liability. vi . Special attention should be paid to customer’s accounts that have become overdue. vii . There should be surprise transfers of travelling Salesmen from one area to another. This will increase the efficiency of the agents and will also reduce the chances of fraud.

21. Internal Check as regard to Cash Sales 3) Postal Sales or Value Payable Post (V.P.P) sales: The following points should be noted in this regard. There should be a separate register to record sales by post of VALUE PAYABLE POST . II. When cash is received against V.P.P sales, it should be entered in the V.P.P register and then it should be posted to the cash book. III. Separate bank pay-in-slips should be used to deposit cash received against post sales. IV. An offer should be deputed to check carefully this register an special attention should be given to those goods that have been returned and those against which payments has not been received . V. Cash book and orders received should be checked and order received should be properly filed too.

22. Internal Check as regard to Cash Purchases Requisition : The procedure for issuing purchase requisitions should be specified. The head of the department, who is in the need of goods, should fill in a requisition slip duly signed and then should send it to the purchases department. The details about the quantity, is quality and the time by which the goods must be supplied be clearly mentioned in the requisition slip . Enquiry : Purchase department makes an enquiry about the terms and conditions of purchases from different suppliers. For this purpose tender are generally invited. But, who shall open and accept the tenders, should be clearly specified. At a rule, the lowest tender should be accepted and accordingly a decision be taken . Purchase Order: The Purchase Department places orders which should be recorded in the Purchase Order book. Four copies of purchase order should be prepared. One copy will be sent to the vendor, second to the store department, third copy to the Accounts department and fourth one will be retained by the purchase department itself. A responsible officer should review the purchase order, before signing by the authorized person or director.

23. Internal Check as regard to Cash Purchases Receipt of Goods: On receipt of goods, the purchase department should be properly inspect them, and there after an entry in the goods inward ( Receipt) book, the same should be sent to the stores. Concerned department should be informed about the receipt of the goods. Making the Payments: The Purchase Department should thoroughly check the invoices and send the same to accounting department for payment. The accounting department should compare the invoice with the purchase order and Incoming Inspection Report and should also verify the calculation. The Accounts Department should enter the invoice in the Purchase Book. Only responsible official should draw cheque for the payment of invoice. At the time of signing, a signing authority must verify that correct payment is made. If some portion of the goods is returned to the supplier, a proper entry must be made in the Purchase Return Book. A Credit Note to that effect must be obtained from the supplier and accounts section must adjust the payment accordingly.

24. Internal Check as regard to Cash Purchases A good system of internal check with regard to purchase will prevent the following types of irregularities, errors and frauds. Fictitious Purchase: Fictitious Purchase may be recorded in the purchase book and the payments withdrawn may be misappropriated. Double Payment: Some invoices may be recorded twice and double payment made may be misappropriated. Artificial inflation in profits: Goods purchased may not be entered in the period so as to inflate profits. Artificial reduction in profits: Goods not received in one period may be entered as purchases so as to show profits less than the actual.

25. Internal Audit Definitions: “Internal Auditing consists of continuous critical review of financial and operating activities by a staff of auditors functioning as full-time salaried employees.” – Watter B. Meigs “Internal Auditing is an independent appraisal function established within an organization to examine and evaluate its activities as a service to the organization. It is a type of control which functions by measuring and evaluating the effectiveness of other types of control.” – The institute of Internal Auditors, U.S.A

26. Objectives of Internal Audit To Comment on the effectiveness of the internal control system in force and to suggest ways and means to improve upon the system. To verify the correctness, accuracy and authenticity of the financial accounting records presented to the management. To facilitate the early detection and prevention of frauds. To ensure that the international accounting standards or the standard accounting practices are followed by the organization. To take up an investigation at the special request o f the management To ensure that the assets of the organization are adequately safeguarded and properly accounted for. To ensure that the organization incurs liabilities in respect of its valid and legitimate activities. To ensure that the acquisition and disposal of assets are under proper authority. To ensure as to whether or not each unit of the organization follows the policies and procedures as laid down by the top management.

27. Basic Principles of Establishing Internal Auditing in a Business Concern Following are the basic principles : 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 .   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 . 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 .

28. Basic Principles of Establishing Internal Auditing in a Business Concern 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.

29. Advantages of internal audit Internal audit provides the following advantages. Prevention of errors and frauds    It helps in the prevention of errors and frauds including misappropriation of cash and goods. Early detection of errors and frauds    It makes early detection of errors and frauds possible. 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. Assurance regarding accuracy of books and accounts    It checks books, records and accounts to ensure correct recording and their maintenance up to date .  

30. Advantages of internal audit Preparation of interim accounts    It facilitates the preparation of interim accounts.   Early completion of annual audit    It is of great use in early completion of annual statutory audit.   Periodic physical verification    It carries out periodic physical verification of assets like cash, stock, investments and items of fixed assets. 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.

31. Disadvantages of internal audit Internal audit suffers from the following limitations. 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.   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.   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.   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.   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.

32. INTERNAL CHECK Vs INTERNAL AUDIT Similarities : Both Internal Check and Internal Audit are part of the whole system of internal control, as such both are complementary and go together. Dissimilarities: There is a lot of difference b/w Internal Check and Internal Audit. Both differ from each other in the following respects. a. Meaning: Internal Check is an arrangement of duties allocated in such a way that the work of one person is automatically checked by another. Internal Audit is an independent appraisal of the operations and records of the company. b. Object: the purpose of Internal Audit is to detect the errors and frauds which have already been committed. The purpose of Internal Check is to prevent or minimize the possibilities of errors, frauds or irregularities. c. Need for separate staff: for carrying out Internal Audit, a separate staff of employees is engaged for the purpose. For internal check, no new appointment is made. It, in fact represents only the arrangement of duties of the staff in a particular way.

33. INTERNAL CHECK Vs INTERNAL AUDIT Contd ….. d. Nature of work: the work involved in the Internal Audit is just like that of a watch man. Internal auditor has to report, from time to time, to the management about the various in efficiencies and suggest improvements. It is also his duty to see that the internal check system does not become static. Internal Check, on the other hand, represents a process under which the work goes on uninterruptedly and the checking too is more or less automatic. e. Timing of work: Internal Audit starts when the accounting process of different transactions is finished. Internal Check is an operation during the course of transaction.

34. Contd …. INTERNAL CHECK Vs INTERNAL AUDIT f . Internal audit: It is a device for checking the work, whereas internal check is a device for doing the work. g. In Internal Audit Errors and Frauds are detected after the completion of work, whereas in Internal Check the Errors and Frauds are discovered during the course of work. h. Scope of work: The scope of Internal Check is very limited. The scope of Internal Audit is comparatively board. i . Involvement: A large number of employees are needed for the implementation of Internal Check System. Whereas, a much smaller number of persons are needed for implementing Internal Audit implementation.

35. End of Unit 2