Internal Control: Definitions, Objectives, Types and Principles

Definitions of internal control

According to SPICER AND PEGLAR, “Internal control is best regarded as the whole system of control financial and otherwise, established by the management in the conduct of a business including internal check, internal audit and other forms of control.”

According to HOWARD F. STETTLER, “Internal control in a broader term is generally used to encompass both internal check and internal audit.”

According to COUNCIL OF THE INSTITUTE OF CHARTERED ACCOUNTANTS OF ENGLAND AND WALES, “Internal control is the whole system of controls financial and otherwise established by the management 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,”

Areas of the internal control

We have seen that the internal control areas spread over accounting and administrative control.

1. Accounting control

It comprises the plan of organization and the procedures and records that are concerned with the safeguarding of assets and the reliability financial records.

2. Administrative control

Administrative control seeks to achieve the aim of management in efficient and orderly conduct of transactions. It seeks to ensure the adherence to management policy in various areas of business operations.

A satisfactory system of internal control depends on the following:

  1. A clear plan of the organisation establishing the line of authority, responsibility and proper division of work.
  2. A well organized and adequate accounting structure with well laid down rules procedures and policies.
  3. Men of ability and experience to execute the work well Proper system of reporting and communication from lower loved management to top management

Objectives of internal control

With the help of internal control following objectives are achieved:

  1. Proper authorization

All the transactions should be carried out with specific sanction and authority. The system should be provided by the management at all level.

  1. Accurate recording

The transaction should be recorded in the book of account regularly. correctly and systematically according to the accounting policies and procedures.

  1. Accountability for assets

There should be complete accountability for all assets. The recorded accountability for assets is compared with existing assets at reasonable intervals and appropriate action is taken with regard to any difference.

  1. Restricted access to assets

The use and access towards assets are made only with proper authority. This would ensure to safeguard the assets from their improper use.

  1. Verification of assets

There should be periodical verification and comparison of assets in existence with accounting records and appropriate action is taken with regard to any difference.

  1. Proper accounting system

That adequate accounting system appropriate size and nature of business is in existence.

  1. Prevention of errors and frauds

Effective internal control prevent the occurrence of errors If there is negligence on the part of one employee. It is pointed out by another employee.

  1. Moral check

In the presence of internal control system there in high level of moral check over the employees. They think several times to act in wrong manners. They remain regular and work effectively.

  1. Reduction of work load

The purpose of internal control is the reduction of work load It reduces the work of auditor and auditor can apply test check to audit the accounts with confidence.

  1. Ensure the compliance

The management of every business make rules land regulation for the achievement of its objects the internal control system ensure the compliance by all the employees to achieve it.

  1. Proper utilization of resources

Internal control system ensures that the expenditure incurred investment made by the Co. to achieve the objects of company.

  1. Misuse of asset

Internal control system ensures the protection of its resources against wastage frauds and inefficient use.

  1. Evaluation of the performance

The internal control helps in evaluating the performance of all the employees and management during the financial year within the organization.

Different types of internal control

Internal control can be categorized as follows:

  1. Organizational

An enterprise should have a plan of organization 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.

  1. By segregation of duties

(a) One person should not be responsible for the recording and processing of a complete transaction.

(b) The involvement of several people reduces the risk of intentional manipulation or; accidental error and increases the element of checking of work.

(c)Functions for a given transaction which should be separated include initiation, authorization, execution, custody and recording.

  1. Physical

(a) This concerns physical custody of assets and involves procedures designed to limit access to authorized personnel only.

(b) Access can be direct or indirect.

(c) These controls are especially important in case of valuable, portable, exchangeable or desirable assets.

  1. By authorization and approval

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

  1. Arithmetical and accounting

(a) These are the controls in the recording function which check that the transactions have been authorized, that they are all included and that they are correctly recorded and accurately processed.

(b) 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.

  1. By personnel

(a) Procedures should be designed to ensure that the personnel operating a system arc 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.

(b) 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.

  1. 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.

  1. By management

(a) These are controls, exercised by management, which are outside and over and above the day-to-day routine of the system.

(b) They include overall supervisory controls, review of management accounts, comparison with budgets, internal audit and any other special review procedures.

Principles of internal control

An effective and strong system of internal control is based on the following principles:

  1. Adequate and competent staff

The first requirement of good internal control system is that an adequate and competent staff should be available for the effective handling of any of the functions. For introducing internal control over any activity, it should be ascertained as to how many men are actually required and what type and status of men are necessary for that function.

  1. Separation of records from custodianship

The internal controls are always effective if functions are separated in the manner that the records and custodianship (in control) are allocated to different bodies. The cashier for instance must not be allowed any access to the books of accounts. Similarly the store keeper should not be allowed to record the issues or receipts in the Bin Cards.

  1. Establishment of responsibility

The scope and areas of responsibility should be defined by the management so that responsibility in the event of some wrong could be traced out. Hence if procedure is introduced without defining the responsibilities of the individuals involved, it would be difficult to locate the responsibility for the error.

  1. Record of proofs of all work done

There should be proofs that the allocated functions were properly discharged by the employees and the requirement of the procedure complied with. The staff should, therefore, initial invoices and bills etc. and indicate that the same have been properly checked.

  1. Review of work done

There should be some system under which the work performance of the individuals may be seen periodically by the senior and superior officers. This will produce good and encouraging results. Surprise checks for this purpose are also recommended.

  1. Physical protection

There should be protection available for company’s property and valuable items. There should be security measures within the area of stock, rooms, in which are lying valuable stores as the possibility of material having gone out unauthorized cannot be ruled out. The protection, if available, assures the management that the chances of fraud or defalcation (embezzlement, fraud) are adequately prevented.

  1. Mechanical accuracy

There should be machines available and tabulated statements should be examined in order to ensure that checks are available on various data and disagreements, if any are properly looked into and investigated. The object of mechanical accuracy is to ensure that mistakes are corrected by the company’s staff in time. In the mechanical accuracy are also included the double entry system of bookkeeping, use of subsidiary ledger, use of control accounts and books of original entry.

  1. Rotation (change over) principles

Clerks should be changed from time to time; no clerk should remain on one job too long. Every clerk should be compelled to take his annual holidays in an unbroken period.

  1. Division and sub-division of work

Work among the staff should be divided in such a way that the work of one employee be checked by the other employee, independently so that errors or fraud could be detected at the same time when they are committed.

  1. detailed records of goods

Detailed record should be maintained of all goods received and sent out.

  1. Use of mechanical appliances

In the absence of adequate staff, fullest possible use should be made of the modern mechanical appliances, such as cash registers, accounting machines etc.

  1. Employees must be bounded

It is necessary that bond should be filled by the employees so that they could remain away from committing fraud. Thus if the employees are bonded, the employer is protected from fraud.

  1. Trust on any employee

Too much confidence should not be pinned on any employees. Because the most frauds are conducted by the most reliable person.

  1. Better salary and other incentives

The management should introduce better salary and incentive for the honest and hard-working employee, it cause increase in efficiency of employees.

Evaluation of internal control

The auditor has to examine and find out as to how far the internal control system is adequate, effective and reliable. Such an evaluation of the internal control will help the auditor to plan and draw his programme of audit work. There are no set rules for such evaluation but there are enquiries, which are to be made.

The auditor through evaluation of internal control can also identify the weaknesses in the system and the areas of weakness. Further, he can plan the areas where detailed examination of the books and accounts of the business is necessary and also curtail detailed examination of other areas where internal control system is satisfactory.

The auditor can also inform the management of the improvements needed in the system and give an objective view of the strength and weakness of the internal control in the business. The evaluation of internal control is recognized as a part of the standard audit procedure.

Company Ordinance 1984 requires the statutory auditor to comment specifically on internal control in his report on the business. Hence the auditor has to evaluate the internal control system of a company incorporated under the ordinance so that he could comment on the system in existence.

An auditor can review and evaluate the effectiveness and reliability of the internal control system of a business through various ways, which are as follows:

  1. Enquire from the management personnel at various organizational levels about the controls in existence and discuss their effectiveness.
  2. Refer the procedural manual (Accounting manuals, office hand books, job charts and flow charts) and find out the functional responsibilities, pathways of work and controls.
  3. Select few transactions and trace them through the accounting system and internal control. Enquire as to the existence and continuance of internal control.
  4. Enquire as to the existence and continuance of internal control system throughout the accounting period of the year under audit.
  5. Collect and record information on internal control system through questionnaires, flow charts and analysis of records and narrative description.
  6. Apply compliance procedures to identify the effective functioning of controls throughout the period of intended reliance.

Methods of internal control evaluation

The auditor can test the actual operations of internal control system by appraisal of duties, application of procedural tests and examination in death. The internal control system in a small business can be evaluated through discussions with management, observation of the accounting procedures, tracing the checks and counter checks in the accounting of transactions and by application of audit tests on procedures followed by the business house.

The auditor may have to follow more formal methods of evaluation of internal control system for big business houses. The auditor may adopt any or all of the following methods to evaluate the effectiveness and reliability of the internal control system.

The methods generally followed are:

  1. Questionnaire method
  2. Flow chart analysis.
  3. Narrative record.
  4. Check list

The above approaches enable the auditor to have sufficient information on the adequacy and effectiveness of the internal control and the areas of weakness in the system. The auditor has to make enquiries of the deviation from prescribed controls. He should also find out the reliability of a particular control and examine the possibility of an alternative control system which would serve more effectively than the present system.

  1. Questionnaire method

The auditor issues questionnaires to the responsible officials on the internal control in operation in business in respect of cash sales, purchases, revenue, expenses, capital expenditure etc., and elicits information on the internal control system in existence. The internal control “questionnaire” is a convenient and efficient method of evaluation. It forms evidence of the review conducted by the auditor on the system.

In U.S.A. through the form of a questionnaire, the auditor finds out the character of the system. Similarly, the exposure draft relating to the statement on the manufacturing and other Companies.

  1. Flow chart analysis

Flow charts are diagrammatic presentation of accounting and internal control system using standardized symbols. Separate flow charts are prepared for each transaction cycle. For example purchases, cash receipts, payroll and sales, flow chart’s highlights.

  1. Flow of documents
  2. Distribution of documents
  3. Flow of information
  4. Built in checks
  5. Segregation of duties
  6. Sequence of operation methods of processing
  7. Methods of processing manual or computerized

3. Narrative record

It contains a complete written description of the internal control system of the business under review as found in operation by the auditor. The type and extent of narrative record is vary as per requirements and individual judgement of each auditor. It clarifies and elucidates all important control points in easiest way.

  1. Check list

It contains the set of instructions to be followed by the auditor and questions to which he must find answers. As soon as an instruction has been followed, he puts his initials in the space provided opposite it. The check list containing questions in generally submitted to the chief accounting executive of the enterprise with a request to write “yes” or “no” or “Not applicable” in answer to each of the questions. After completing the check list for all individual departments, the auditor makes his own tests and requires ascertaining that the procedures and practices being actually followed are in conformity with answers.

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