INTERNAL CONTROLS PAGE 361 INTERNAL CONTROLS Objectives When

INTERNAL CONTROLS PAGE 361

INTERNAL CONTROLS Objectives: When you have finished this chapter you should be able to: - Discuss the nature and importance of internal controls - Explain the procedures that should be implemented in controlling cash, credit, inventories and non-current assets

INTERNAL CONTROLS What is Internal Control? Internal control of a business enterprise involves those internal methods and measures that ensure efficient management of the enterprise and achievement of planned objectives

INTERNAL CONTROLS What are the aims of internal control? - To safeguard the assets of the business - To check the accuracy and reliability of the business’s accounting data - To promote operational efficiency - To encourage adherence to prescribed managerial policies (follow and abide by the policies of the business)

INTERNAL CONTROLS What are the two types of internal controls? 1. Accounting controls: are the methods and procedures designed to safeguard the assets of the business and to check the accuracy and reliability of its accounting data. 2. Administrative controls: are the methods and procedures designed to promote operational efficiency and to encourage adherence to prescribed managerial policies.

INTERNAL CONTROLS Internal accounting controls are built around the following seven principles: 1. 2. 3. 4. 5. 6. 7. Reliable, competent personnel Verification Authorisation Responsibility Separation of duties/rotation of duties Adequate and accurate documents and records Physical controls and security

INTERNAL CONTROLS Internal accounting controls are built around the following seven principles: 1. Reliable, competent personnel - It’s vital that companies employ qualified people and give them duties and responsibilities that are commensurate with their abilities. - Employees also need to realise the importance of following internal control procedures

INTERNAL CONTROLS Internal accounting controls are built around the following seven principles: 2. Verification - Verification is the act of checking the accuracy of accounting records. - One important way is to compare the physical asset with the accounting record relating to it - Eg. The bank reconciliation process verifies the business’s records with the independent bank’s records, or a trial balance verifies that debits equal credits, and if they do not an error has occurred.

INTERNAL CONTROLS Internal accounting controls are built around the following seven principles: 3. Authorisation - Means that a person in a position of responsibility or authority will validate a course of action - Eg. Before any order is made, the appropriate person/officer needs to sign it.

INTERNAL CONTROLS Internal accounting controls are built around the following seven principles: 4. Responsibility - Each employee has a defined area of responsibility so that actions can be traced back to the responsible individual if some query arises - Being responsible for your actions/work promotes greater care and efficiency.

INTERNAL CONTROLS Internal accounting controls are built around the following seven principles: 5. Separation of duties/rotation of duties - Separation of duties means the separation of authorization, recording and physical handling of the asset. - This reduces the chance of fraud- wrongful or criminal deception intended to result in financial/personal gain - Employees should also rotate duties as much as possible, and be forced to take annual leave- often this is the only way that errors and dishonesty can be detected.

INTERNAL CONTROLS Internal accounting controls are built around the following seven principles: 6. Adequate and accurate documents and records - Documents should be: - Consecutively numbered to control missing documents and aid location - Simple in design to ensure accuracy of completion - Prepared as soon as possible after transactions take place - Devices such as cash registers, barcode readers and computers are used to ensure accuracy of recording - Computer programs also ensure that valid data is entered (eg. Valid credit card numbers, checking for credit limits)

INTERNAL CONTROLS Internal accounting controls are built around the following seven principles: 7. Physical controls and security - Relates to the controls that physically safeguard the assets, particularly cash, inventories and non-current assets. - Includes keys, employee identification cards, cash registers, safes, secure areas for storage of inventories, video surveillance, after-hours security, fire protection and adequate insurance. - The extent of internal controls will depend on the size of the business, and other factors such as location, types of products and management/ownership.

INTERNAL CONTROLS - CASH

INTERNAL CONTROLS - CASH Cash is an important asset for the following reasons: - Most business transactions eventually lead to the business receiving cash or paying cash - Because cash is easily stolen, adequate controls must be implemented to ensure that people with dishonest intentions are detected. Effective management of cash includes: - Preparing cash budgets - Investing excess cash to maximize revenue - Ensuring appropriate controls are implemented

INTERNAL CONTROLS - CASH General internal controls over cash • All money received should be evidenced by a document or other proof • All cash received should be banked ‘intact’ at the end of each business day- intact means payments should not be made out of the day’s receipts • All cash payments should be made by cheque or electronic funds transfer (EFT), except when amounts are small enough to be paid through a petty cash fund • All cash should be kept in a safe place- in a safe • At regular intervals, check business’s records with bank’s records • Separation of duties amongst staff- those who handle cash shouldn’t record it • Rotation of duties allows mistakes to be found and less chance of fraud occurring.

INTERNAL CONTROLS - CASH Applying internal controls to cash receipts (when cash is received) Two important control factors over cash sales are: - Calculating the actual amount of cash (including coins, notes, cheques and credit/debit card vouchers) received each day - Carrying out some check to ensure that was received is the amount that should have been received. - Sometimes money is paid straight into the business’s bank account through EFT deposits. For example regular receipts such as rent received and customers paying their account by EFT are examples of this- this business is made aware of these receipts when the bank statement is received.

INTERNAL CONTROLS - CASH Applying internal controls to cash payments (money leaving the business) • The major internal control over cash payments is that all payments should be made by cheques or EFT. • A typical ‘payment by cheque’ system should have the following features: - All cheques should be prenumbered in serial order and crossed ‘Not Negotiable’. Any cancelled cheques should be kept for auditing purposes. Unused cheques should be kept in a safe place. - Evidence is necessary to ensure that only legitimate expenditures will be made. Evidence in the form of checked and validated orders, tax invoices and/or statements of account should be produced before a cheque is drawn. - All cheques or EFT payments should be properly authorized. For added precaution, two signatures are often required on a cheque or payment voucher - A regular bank reconciliation statement should be prepared by a person who did not prepare, authorize or sign the cheques or payment vouchers, and who was not involved with the keeping of accounts payable records. Another method of controlling payments by employers is the use of a corporate credit card- employees can make payments and it will be verified and paid in the usual manner. -

INTERNAL CONTROLS - CASH Using the information we have just looked at, answer question 10. 10 on pages 369 -370.

INTERNAL CONTROLS - CASH Petty Cash - The purpose of the petty cash fund is to facilitate the payment and recording of items that are individually too small for a cheque to be drawn or an EFT payment to be made. - The recording of petty cash is generally controlled by a junior clerk, who is known as the ‘petty cashier’. - Whenever employees require cash, a document called a ‘petty cash voucher’ must be completed and authorized. The voucher must be accompanied by evidence of expenditure - such as a cash register docket, receipt or bus ticket- and provide evidence for the writing up of a petty cash book. - Example of ‘The Imprest System” on pages 370 -371

INTERNAL CONTROLS - Credit (Accounts Receivable and Accounts Payable)

INTERNAL CONTROLS - Credit (Accounts Receivable and Accounts Payable) Importance of Credit - Control over credit is becoming more important because of the tendency to rely less on cash and to use credit cards and credit facilities provided. - Many business transactions are carried out on credit basis, such as the purchasing and selling of inventories. - These credit transactions create accounts receivable and payable, and adequate controls must be implemented over them.

INTERNAL CONTROLS - Credit (Accounts Receivable and Accounts Payable) Internal control over accounts receivable

INTERNAL CONTROLS - Credit (Accounts Receivable and Accounts Payable) Internal control over accounts receivable • Credit approval: - all customers who apply for credit must be investigated for their credit worthinessneed to look at things such as length of time in business, amount of income/profit, ability to pay debts, past credit history and credit ratings from other firms. - Businesses must have a credit policy and must decide on the following: - The number of days given for accounts receivable to pay - Whether or not discounts for early payment will be given - The amount of interest (if any) that will be charged on overdue accounts

INTERNAL CONTROLS - Credit (Accounts Receivable and Accounts Payable) Internal control over accounts receivable • Recording and Billing: - The use of control accounts and subsidiary ledgers occurs through comparison of the schedule of accounts receivable with the control account in the general ledger. - Tax invoices are the main documents that certifies that a credit sale has taken place. - Adjustment/credit notes certify that a sales return or allowance has occurred - Statements of account should be sent at regular intervals to accounts receivable so that cash from these credit sales is collected as soon as possible.

INTERNAL CONTROLS - Credit (Accounts Receivable and Accounts Payable) Internal control over accounts receivable • Reporting and separation of duties: - Each accounts receivable must be monitored to ensure that debts are paid on time. - Accounts receivable must constantly be reminded of their debts- contact by phone, send out reminder notices, threat of court action - If all procedures fail to collect the money owing, the account may have to be written off as a bad debt. - Person who handles the physical assets of cash or inventories should not have access to the accounts receivable records

INTERNAL CONTROLS - Credit (Accounts Receivable and Accounts Payable) Internal control over accounts payable

INTERNAL CONTROLS - Credit (Accounts Receivable and Accounts Payable) Internal control over accounts payable Proper Authorisation - Before goods are ordered suppliers should be approved on the basis of price, quality, and ability to fill orders on time. - Business should try to have access to two or more sources for as many goods as possible.

INTERNAL CONTROLS - Credit (Accounts Receivable and Accounts Payable) Internal control over accounts payable Recording, prompt payment, separation of duties - Use of control accounts and subsidiary (extra) ledgers allows greater control through comparison of the control account in the general ledger with the schedule of accounts payable - Payments should be made promptly, especially within discount periods- also helps reputation of business - People handling accounts payable records should not handle payment of cash or receipt of inventories

INTERNAL CONTROLS - Credit (Accounts Receivable and Accounts Payable) Corporate Credit Cards - These cards allow employees to make legitimate credit purchases on behalf of the business. - Control must be kept over these cards to ensure that they are used only by authorized people and only for business purposes. - Verification of these expenses will be carried out before payment is made.

INTERNAL CONTROLS - Inventories

INTERNAL CONTROLS - Inventories Importance of Inventories - They are an integral part of profit determination- they are used in calculating any inventory adjustment to be included in cost of goods sold and therefore have a great bearing on the profit figure. Cost of Goods Sold = Opening stock + purchases – closing stock Gross profit = Sales - Cost of Goods sold - Inventories should be turned over quickly- the faster you sell stock, the greater the opportunity to make profits.

INTERNAL CONTROLS - Inventories Importance of Inventories - Because large amounts of money are invested in inventories, adequate controls must be implemented so that theft and other losses are kept to a minimum. - Store cameras, store detectives, inspection of shopping bags and curved mirrors are used to prevent theft by customers. - Quantity of inventories must be carefully monitored- don’t keep too many or too few inventories - Quality and type of inventories are very important. - constant checks should be carried out to ensure they are not out of date, the wrong colour or size, of poor quality. - Depending on size of business these procedures might be shared or performed individually.

INTERNAL CONTROLS - Inventories Stocktaking - If a business keeps inventories as part of its normal operations, an annual physical stocktake is a necessity. - Stocktaking is the process of listing, counting and valuing unsold inventories on hand. - It is necessary for two main reasons: - It is needed to determine the value of the inventories on hand at a particular date (used in Balance sheet) - It is the only way of determining actual inventories on hand- this way the figure can be compared with what should have been on hand therefore any theft or spoilage is evident.

INTERNAL CONTROLS - Inventories Internal control over the purchase of inventories - When ordering inventories, the longer the lead time (eg. If the goods have to come from overseas) the higher the reorder point and the higher the reorder quantity. The opposite applies for shorter lead times. - When the goods are ordered, a purchase order or an order form is despatched to the supplier. - When goods are received, a delivery docket or despatch docket will accompany the goodscare must be taken to ensure that the goods received are in fact the goods ordered.

INTERNAL CONTROLS - Inventories Internal control over the sale of inventories - Orders may be received over the counter, by post, by telephone, from salespeople or electronically (bank transfers, wesbsites) - If orders are not received electronically, they are generally entered onto a standardized sales order to be processed by the organization - When order is filled, the details are recorded on an original tax invoice and an original dispatch docket- copies are kept by business. - If goods are returned to business, an original adjustment/credit note will be sent and a copy kept by the business. - If goods are sold for cash, a cash register summary is generally used.

INTERNAL CONTROLS - Inventories Internal control over stored inventories - Loss of stock through theft, damage, deterioration or obsolescence (out-dated, old) can lead to lower sales and therefore lower profit. - Controls are generally exercised over: - Location - Security - Turnover

INTERNAL CONTROLS - Non-Current Assets

INTERNAL CONTROLS - Non-Current Assets Importance of non-current assets - Non-current assets consist of property, plant and equipment, other financial assets (investments), and intangibles (things you can’t physically touch) - They are specifically used or bought because they will help the business grow and make profits. - it is therefore necessary to implement controls over these long-term assets.

INTERNAL CONTROLS - Non-Current Assets Internal control over property, plant and equipment - Property, plant and equipment assets require controls over their purchase, storage and disposal - The most important control over these assets is the property, plant and equipment register - A register of multiple items of property, plant and equipment enables: - Proper control over such assets through the use of the control account-subsidiary ledger technique- the control account is the asset account in the General ledger and the subsidiary ledger consists of the individual property, plant and equipment registers. - Accurate accounting for property, plant and equipment - The register may consist of cards (one for each asset) or a computer file for each asset.

INTERNAL CONTROLS - Non-Current Assets Internal control over the purchase of property, plant and equipment - Authorisation: Higher level management must authorize such major purchases. All purchase orders must show this authorization - Selection: When purchasing machinery, for example, it is important that all technical details regarding performance, operation, reliability etc. should be examined by a suitably qualified member of the business. This is because such purchases mean the business is committing to large payments and long ownership of these assets. - Proof of ownership: the purchase of these assets is usually accompanies by proof of ownership, such as title deeds to property. These are valuable and should be kept in a safe or a bank safety deposit box. - Payment of Cash: Once the purchase of an asset is authorized, it becomes a normal cash payment.

INTERNAL CONTROLS - Non-Current Assets Internal control over the storage of property, plant and equipment - Whether the assets are movable or remain in one location for their entire life, control over their storage must be exercised in the following areas: - Location: All assets should be identified in some way, usually by a number. The property, plant and equipment register identifies the assets owned and their designated location- regular checks should be made. - Maintenance: it is essential that the assets be kept in good working order - Protection: The assets must be protected against theft or damage. Therefore, once again regular checks should be made to ensure they are on hand. Adequate insurance cover should also be maintained against any unforeseen circumstances.

INTERNAL CONTROLS - Non-Current Assets Internal control over the disposal of property, plant and equipment - Authorisation: As with purchases, the disposal of these assets needs proper authorization by higher level management. This is to prevent an unauthorized employee selling valuable assets. - Physical disposal: This could take place by outright sale, tender, trade-in or scrapping. Whatever method is chosen, the best possible price should be obtained. A properly authorized person must be in charge of the physical disposal of the asset. - Disposal of the asset is then recorded in the property, plant and equipment register.

INTERNAL CONTROLS - Non-Current Assets Internal control over other non-current assets - Investments and other financial assets: Proper authorization by suitable qualified individuals must occur so that maximum returns are obtained by the business. Suitable records must be kept and ny returns accounted for. Authorisation must be obtained for any disposal. - Patents and copyrights: These can be very valuable to the business. Controls should be put into place to ensure that these are registered correctly and to ensure that any breaches are dealt with in the appropriate manner. This would require the services of suitably qualified staff or external experts in the field.